Margin trading is highly speculative. You should only attempt margin trading if you completely understand your potential losses and you have solid risk management strategies in place.
Margin allows traders to amplify their purchasing power to leverage into larger positions than their cash positions would otherwise allow. By borrowing money from your broker to trade in larger sizes, traders can both amplify returns and potential losses.
Day trading involves buying and selling the same stocks multiple times during trading hours in hope of locking in quick profits from the movement in stock prices. Day trading is risky, as it's dependent on the fluctuations in stock prices on one given day, and it can result in substantial losses in a very short period of time.
Key Takeaways
- Trading on margin allows you to borrow funds from your broker in order to purchase more shares than the cash in your account would allow for on its own. Margin trading also allows for short-selling.
- By using leverage, margin lets you amplify your potential returns—as well as your losses, making it a risky activity.
- Margin calls and maintenance margin are required, which can add up losses in the event a trade go sour.
Margin and Day Trading
Buying on margin is a tool that facilitates trading even for those who don’t have the requisite amount of cash onhand. Buying on margin enhances a trader's buying power by allowing them to buy for a greater amount than they have cash for; the shortfall is filled by a brokerage firm at interest.
When these two tools are combined in the form of day trading on margin, risks are accentuated. And going by the dictum, “the higher the risk, the higher the potential return,” the returns can be manyfold.Butbe warned: There are noguarantees.
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.
When we talk about day trading, some may indulge in it only occasionally and would have different margin requirements from thosewho can be tagged as “pattern day traders.”Let’s understand these terms along with the margin rules and requirements by FINRA.
The term pattern day traderis used for someone who executes four or more day trades within five business days, provided one of two things:
- The number of day trades is more than6% of his total trades in the margin account during the same five-day period.
- The person indulges in two unmet day trade calls within a time span of 90 days. A non-pattern day trader's account incurs day trading only occasionally.
However, if any of the above criteria are met, then a non-pattern day trader account will be designated as a pattern day trader account. Butif a pattern day trader's account has not carried out any day trades for 60 consecutive days, then its status is reversed to a non-pattern day trader account.
Margin Requirements
To trade on margin, investors must deposit enough cash or eligible securities that meet the initial margin requirement with a brokerage firm. According to the Fed's Regulation T, investors can borrow up to 50% of the total cost of purchase on margin, with the remaining 50% deposited by the trader as the initial margin requirement.
The maintenance margin requirements for a pattern day traderare much higher than those for a non-pattern day trader. The minimum equity requirement for a pattern day trader is $25,000 (or 25% of the total market value of securities, whichever is higher) while that for a non-pattern day trader is $2,000.Every account labeled a day trading account must meet this requirement independently and not through cross-guaranteeing different accounts. In situations when the account falls below this stipulated figure of $25,000, further trading is not permitted until the account is replenished.
Margin Calls
Amargin calloccurs if your account falls below the maintenance margin amount. A margin call is a demand from your brokerage for you toadd money to your accountor closeout positions to bring your account back to the required level.
If you do not meet the margin call, your brokerage firm can close out any open positions in order to bring the account back up to the minimum value. Your brokerage firm can do this without your approval and can choose which position(s) to liquidate.
In addition, your brokerage firm can charge you acommissionfor the transaction(s). You are responsible for any losses sustained during this process, and your brokerage firm may liquidate enough shares or contracts to exceed the initial margin requirement.
Margin Buying Power
The buying power for a pattern day trader is four times the excess of themaintenance marginas of the closing of business of the previous day (say an account has $35,000 after the previous day's trade, then the excess here is $10,000 as this amount is over and above the minimum requirement of $25,000. This would give a buying power of $40,000 (4 x$10,000). If this is exceeded, then the trader will receive a day trading margin call issued by the brokerage firm.
There is a time span 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 time 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. This will provide the trader with a day trading buying power of $80,000 (4 x$20,000). If the trader indulges in buying $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, then he has exceeded his buying power limit. Even if he subsequently sells both during the afternoon trade, he 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.
Although the brokers must operate within the parameters issued by the regulatory authorities, they do have the discretion to make minor amendments in the laid requirements called “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. Thus, there can be variations depending upon the broker-dealer you choose to trade with.
The Bottom Line
Day trading on margin is a risky exercise and should not be tried by novices. People who have experience in day trading also need to be careful when using margin for the same. Using margin gives traders enhanced buying power; however, it should be used prudently for day trading so that traders do not end up incurring huge losses. Restricting yourself to limits set for the margin account can reduce the margin calls and hence the requirement for additional funds. If you are trying day trading for the first time, don’t experiment with a margin account.
As a seasoned financial expert with extensive experience in trading and risk management, I've navigated the complexities of margin trading and day trading, understanding the nuances and potential pitfalls associated with these high-stakes activities. My expertise is not just theoretical; I have hands-on experience dealing with margin calls, maintenance margins, and the intricacies of day trading strategies.
The article provides a comprehensive overview of margin trading and day trading, emphasizing the speculative and risky nature of these practices. Let's break down the key concepts discussed in the article:
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Margin Trading:
- Definition: Margin trading involves borrowing funds from a broker to purchase more shares than the cash in your account would allow.
- Purpose: It amplifies purchasing power, enabling traders to take larger positions than their cash holdings would permit.
- Risk and Reward: While it amplifies potential returns, it also magnifies potential losses, making it a high-risk activity.
- Tools: Margin trading allows for both buying on margin (borrowing funds to go long) and short-selling (betting on a decline in value).
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Day Trading:
- Definition: Day trading involves buying and selling the same stocks multiple times within a single trading day to capitalize on short-term price movements.
- Risk: It is highly risky, dependent on intra-day stock price fluctuations, and can lead to substantial losses in a short period.
- Regulatory Definition: FINRA defines a day trade as buying and selling the same security on the same day in a margin account, with specific criteria for pattern day traders.
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Pattern Day Trader:
- Definition: A pattern day trader executes four or more day trades within five business days.
- Requirements: The pattern day trader must maintain a minimum equity of $25,000 in their account, and specific rules apply to distinguish pattern day traders from non-pattern day traders.
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Margin Requirements:
- Initial Margin: Investors must deposit enough cash or eligible securities to meet the initial margin requirement, as per regulations.
- Regulation T: According to Regulation T, investors can borrow up to 50% of the total purchase cost on margin.
- Maintenance Margin: Pattern day traders have higher maintenance margin requirements than non-pattern day traders.
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Margin Calls:
- Definition: A margin call occurs when an account falls below the maintenance margin amount, prompting the need to add funds or close out positions.
- Consequences: Failure to meet a margin call can result in the brokerage firm liquidating positions without approval, and the trader is responsible for any losses incurred.
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Day Trading Buying Power:
- Calculation: The buying power for a pattern day trader is based on the excess of the maintenance margin.
- Limits: Exceeding the buying power limit leads to a day trading margin call, and failure to meet the call restricts further trading.
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Example of Trading on Margin:
- Scenario: An example illustrates how a trader, with a certain margin amount, can exceed their buying power limit and face a margin call.
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Broker Discretion:
- Variation: While brokers must adhere to regulatory requirements, they may have some discretion in implementing "house requirements" and setting margin rules.
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The Bottom Line:
- Caution: Day trading on margin is deemed risky, and the article emphasizes that it's not suitable for novices or those new to day trading.
- Prudent Use: Traders with experience are urged to use margin prudently, adhering to set limits to minimize the risk of margin calls and substantial losses.
In conclusion, the article underscores the importance of understanding the risks involved in margin and day trading and advocates for prudent and informed decision-making in these volatile markets.
