How Margin Agreements Work - dummies

How Margin Agreements Work

The more money you have to trade on the stock market, the more dollars you can generate as a day trader, even if the return on the trade itself is small. This is why some day traders take on the risk of leveraging — or borrowing — to fill their positions.

If you have $500,000 and borrow $500,000 more, then your 10-percent return gives you $100,000 to take home, not $50,000. You’ve doubled the dollars returned to you by doubling the money you used to place the trades, not by doubling the performance of the trade itself.

Leverage not only adds risk to your own account, but it also adds risk to the entire financial system. If everyone borrowed money and then some big market catastrophe happened, no one would be able to repay their loans, and those who lent the money would go bust, too.

As a result, an incredible amount of oversight goes with leverage strategies. The Securities and Exchange Commission, the Commodity Futures Trading Commission, the different exchanges, and even the U.S. Treasury Department regulate how much money a trader can borrow.

Many brokerage firms have even stricter rules in place as part of their risk management, and they’re expected to demonstrate to the National Association of Securities Dealers and the National Futures Association that they follow their practices.

This extensive oversight means that you have about as much flexibility when you borrow from your broker to buy and sell securities as you would have if you borrowed from your friendly neighborhood loan shark to play a high-stakes poker game. In other words, not much.

Margin loans are highly regulated, and you must meet the broker’s terms. If you fail to repay the loan, your positions will be sold from underneath you. If you try to borrow too much, you will be cut off. No amount of begging and pleading will help you.

Your brokerage firm makes you sign a margin agreement, which says that you understand the risks and limits of your activities. You probably can’t have a margin account unless you meet a minimum account size, maybe $10,000 or more, and the amount you can borrow depends on the size of your account.

Generally, a stock or bond account must hold 50 percent of the purchase price of securities when you borrow the money. The price of those securities can go down, but if they go down so much that the account ends up holding only 25 percent of the value of the loan, you get a margin call. (Some brokers call in loans faster than others; their policies are disclosed in their margin agreements.)

Brokerage firms handle margin trades all the time. You do the paperwork once, when you sign a margin agreement. Then each time you place an order, you’re asked whether you’re making the trade with cash or on margin. Click the box marked “Margin,” and you’ve just borrowed money. It’s that easy.

Here are two important things to remember about leverage:

  • Leverage gives you more money to trade, which helps you generate more dollars for your account — or lose more dollars, if you aren’t careful or have a string of reversals.

  • When you borrow money or shares of stock, you have to pay it back, no matter what happens. That’s why borrowing can be risky.

Day traders and other short-term traders aren’t looking to make big money on any single trade. Instead, the goal is to make small money on a whole bunch of trades.