Margin trading is highly speculative and investors should understand the potential losses and have solid risk management strategies.Margin trading allows traders to increase their purchasing power to leverage into larger positions than their cash positions would otherwise allow. By borrowing money from a broker to trade in larger sizes, traders can amplify returns and losses.
Day trading is buying and selling the same stocks multiple times during trading hours for quick profits. Day trading is risky, as it's dependent on fluctuations in stock prices and can result in substantial losses in a very short period.
Key Takeaways
- Margin trading allows investors to borrow funds to purchase more shares than the cash in their accounts allows.
- By using leverage, margin can amplify potential returns and losses.
- Margin calls and maintenance margins are required, which can add up losses if a trade goes sour.
Margin and Day Trading
Buying on margin facilitates trading for those who don’t have the requisite amount of cash onhand. The cash shortfall is fulfilled by a brokerage firm, which charges interest. When day trading on margin, risks are accentuated.
The Financial Industry Regulatory Authority (FINRA) rules define a day trade as“The purchasing and selling or the selling and purchasing of the same security on the same day in a margin account.” The short-selling and purchases to cover the same security on the same day along with options also fall under the purview of a day trade.
Pattern Day Trading
The term pattern day traderis used for someone who executes four or more day trades within five business days. Additionally, if these criteria are met, a non-pattern day trader account will be designated a pattern day trader account:
- The number of day trades is more than6% of their total trades in the margin account during the same five-day period.
- The person indulges in two unmet day trade calls within 90 days. A non-pattern day trader's account incurs day trading only occasionally.
Margin Requirements
Minimum Margin: Before individuals can borrow or trade on margin, FINRA requires a "minimum margin." Investors must deposit a minimum of $2,000 or 100% percent of the purchase price of the margin securities, whichever is less,with their brokerage firm.
Initial Margin: To borrow on margin, investors must deposit enough cash or eligible securities that meet an initial margin requirement with a brokerage firm. According to the Fed's Regulation T, investors can borrow up to 50% of the total cost on margin.
Maintenance Requirement: FINRA rules require brokerage firms to impose a “maintenance requirement” on margin accounts that defines the minimum amount of equity investors must maintain in their margin accounts. The maintenance margin requirement for a pattern day traderis $25,000 (or 25% of the total market value of securities, whichever is higher) and higher than that for a non-pattern day trader, a minimum margin of $2,000.
Amargin calloccurs when an account falls below the maintenance margin amount. A margin call requires tradersto add money to their accountsor close positions.
Margin Buying Power
The buying power for a pattern day trader is four times the excess of themaintenance marginas of the closing of business on the previous day. An account with $35,000 after the previous day's trade, holds an excess of $10,000 over the minimum requirement of $25,000. This equals a buying power of $40,000 (4 x$10,000). If this is exceeded, the trader will receive a day trading margin call issued by the brokerage firm.
There is a time of five business days to meet the margin call. During this period, the day trading buying power is restricted to two times the maintenance margin excess. In case of failure to meet the margin during the stipulated period, further trading is only allowed on a cash available basis for 90 days, or until the call is met.
Example of Trading on Margin
Assume that a trader has $20,000 more than the maintenance margin amount. The trader has a trading buying power of $80,000 (4 x$20,000). If the trader buys $80,000 of PQR Corp at 9:45 a.m. followed by $60,000 of XYZ Corp. at 10.05 a.m. on the same day, they have exceeded their buying power limit.
Even if they subsequently sell both during the afternoon trade, they will receive a day trading margin call the next day. However, the trader could have avoided the margin call by selling off PQR Corp before buying XYZ Corp.
What Happens When a Trader Does Not Meet the Maintenance Margin Amount?
With a margin call, a brokerage firm can close out any open positions to bring the account back up to the minimum value. A brokerage firm can do this without approval and chooses which position(s) to liquidate. Traders may be charged acommissionfor the transactions.
Can Brokerage Firms Set Their Own Rules on Margin Trading?
Although brokers must operate within the parameters issued by the regulatory authorities, they may make minor amendments to the “house requirements.”A broker-dealer may classify a customer as a pattern day trader by bringing them under their broader definition of a pattern day trader. Also, brokerage firms may impose higher margin requirements or restrict buying power.
How Does Interest Affect a Margin Account?
Trading on margin means an investor is taking a loan, which charges interest. This interest can reduce a trader's return on investment. Interest rates can vary between brokerage firms.
The Bottom Line
Day trading on margin is risky. A margin account is a loan to purchase securities and investors will pay interest for this type of leverage. Using margin gives traders enhanced buying power, but can come with substantial losses.
