Margin Trading

Day trading on margin – using borrowed money to leverage one’s trading results – is a speculative practice that multiplies results by some factor. When done successfully it greatly increases a trader’s profit, but it can also be very dangerous. Margin trading is not for novice traders, who have yet to establish effective strategies and risk management practices. Here we explain what margin trading is and list the best brokers to get started.

What is Margin Trading?

Margin trading works to amplify gains and losses. Indeed, the central purpose is to augment trading profits, but trading should always be considered from a “defensive” perspective, as playing good defence is what will keep you in the game over the long run.

Day traders often make multiple transactions per day to profit off relatively small fluctuations in the market traded. Therefore, if you go on a cold streak where the market moves against you, trading with leverage can wipe out a substantive fraction of your trading balance in short order.

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Margin Calculator

Many brokers, such as XM and Interactive Brokers, provide margin trading calculators. Take a look at the margin calculator at XM to see what a trade might cost to open.

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For day traders, brokers providing or raising margin funding will often have different levels available for swing or position traders who have longer holding periods.

Day traders can typically borrow up to 4x the amount of cash they’ve deposited beyond the minimum equity requirement based on standard Regulation T (“Reg-T”) rules.

For those who hold positions overnight, it is generally limited to 2x.

Naturally, you will want to check with your broker and the laws within your particular jurisdiction. (More on this below.)

The idea behind allowing day traders to borrow more heavily than longer-term traders is because the smaller holding periods are less likely to result in a security moving materially. Therefore, the expected drawdown or potential loss on any given position is less. This carries the stipulation that positions must be closed overnight.

Any leverage beyond that permitted for overnight trading will result in a margin call and automatic liquidation by your broker.

Traders and investors in the Indian markets will see very similar concepts and margin trading approaches, though the terminology may differ. As Indian brokers automatically close positions at the end of the trading day, they make a distinction between day trading, called intraday trading, and longer-term trading, called delivery trading.

Margin trading is accessible with most instrument types, from equities to commodity CFDs and futures. Most brokers stick with low intraday margin rates, while delivery trading is more expensive.

See a list of brokers with the lowest margin rates.

Pattern Day Traders vs Non-Pattern (US only)

Note that the rules and regulations can be very different depending on jurisdiction and trader classification.

This section applies only to US traders, where regulation makes a distinction between the so-called “pattern day traders” and those that are not.

Pattern day traders are classified as those who execute four or more day trades within five business days, given that one or more of the following is fulfilled:

a) The number of day trades is more than 6% of the total trades during the same five-day period. Therefore, if an individual executes four-day trades within one week and executes fewer than 67 other types of trades (to satisfy the 6% rule), he or she will be classified as a pattern day trader.

OR

b) The individual engages in two unmet day trade calls within 90 days (i.e., goes over the buying power limitation more than once within 90 days).

OR

c) The brokerage firm you trade with – through its own discretion – can also designate you as a pattern day trader if it has reason to believe you should be classified as one. This can happen in cases where, for example, it provided day trading training to you before you officially registered.

More frequently asked questions about this matter can be found on the official FINRA website.

If none of the above criteria is met, then a trader will receive a non-pattern day trader classification. Moreover, if a pattern day trader does not execute any day trades for 60 consecutive days, then his or her account will be altered to a non-pattern day trader solution automatically.

Why “Pattern” vs. “Non-Pattern” Matters

The answer comes down to margin requirements.

For pattern day traders, the margin requirements are significantly higher. This means that pattern day traders must meet a higher minimum equity requirement than non-pattern day traders.

Pattern day traders must maintain a minimum of $25,000 or 25% of the total market value of securities in their balance, whichever amount is greater. On the other hand, non-pattern day traders generally have a minimum equity requirement of $2,000. If a balance falls below the minimum equity requirement, trading will be suspended until the required amount is met again.

Pattern day traders are allowed to purchase up to four times the amount over the $25,000 minimum equity requirement. For example, if a trader deposits $40,000, that amount is $15,000 over the requirement ($40,000 – $25,000). Applying the 4x rule means the trader can trade up to $60,000 (i.e., $15,000 multiplied by four) worth of securities.

Margin Calls

If a trader exceeds the maximum amount allowed for trading, the broker will issue a margin call. The trader will be given five business days to meet the call by reducing the number of securities owned to an acceptable level.

The broker will often automatically liquidate positions to bring the trader’s balance back within an acceptable level. If the trader fails to meet the margin call during the allotted five business days, trading will be permitted on a cash-only basis. Additionally, day trading buying power will be restricted to two times the maintenance margin excess during the intervening period between the issuance of the call and meeting it.

This can be reversed once the margin call is met.

Margin calls will be sent out so long as buying power has been breached irrespective of whether positions were sold that same day.

For example, if a trader has $25,000 above his maintenance margin amount and decides to buy $110,000 of a particular stock (above the 4x stipulation), even if he buys and sells that position within the same market hours he will receive a margin warning or call either immediately or the next business day.

Please note that these rules are not set in stone and can vary by the broker you trade with and/or the jurisdiction you are trading in.

Brokers often layout their own rules and have the latitude to modify and adopt rules of their own to protect their personal business interests.

This can mean broadening the rules regarding what a pattern day trader is, enforcing certain minimum equity requirements, or restraining the buying power of certain clients.

You must always check with your broker before signing up to understand what exactly is required and what specific rules might apply.

Having Realistic Expectations

If you choose to day trade on margin, understanding the risks is imperative.Small fluctuations in the price of your owned securities can lead to outsized moves in the price of your portfolio.

Using broker margin lending services may allow you to trade with money you don’t currently have and help with issues of under capitalisation that many traders have.

However, this of course isn’t going to help you make more money if you don’t have a viable trading strategy or effective risk management practices.

Trading is not a realistic way to get rich quickly. Making a living off trading requires having a capital base of sufficient size. Nobody will be able to make a living off trading with just a few thousand dollars.

To back out how much of a capital base you’ll need to make a living day trading, you need to start with how much income you require from trading and divide that by your expected percentage return each year.

For instance, the S&P 500 is expected to return about 7% per year in nominal terms going forward. Most hedge funds, which employ very smart and sophisticated investors, fail to reach this annualised return.

But obtaining this mark can be a realistic goal. So, if one were to need $50,000 per year to meet their income goal, this would require a capital base of slightly more than $700,000 ($50,000 / 0.07). And note that markets don’t consistently give you X% return per year.

There will be fluctuations, sometimes wild ones, depending on your strategy and risk management. There is no such thing as a safe 7% return, and if you day trade you probably follow volatile markets, such as equities, commodities, and/or currencies.

Nonetheless, when properly utilised, margin can be a good thing and help push one’s expected returns up to a risk level one is comfortable with.

Margin trading can also be safer than standard cash-only trading when it incentivises a trader to take a low-to-moderate-risk strategy – knowing leverage will help increase whatever gains are made – rather than a high-risk strategy to compensate, such as taking large concentrated positions in high-risk securities.

Final Thoughts

Day trading on margin can be risky, and should not be tried by beginning traders.

However, for experienced traders with profitable trading strategies and systems in place, using low to moderate amounts of leverage can actually be a less risky endeavour than using no leverage and chasing returns with suboptimal trading strategies.

FAQ

If this happens, the broker would often automatically liquify open positions to recover the missing capital.

If this does not amount to enough cash, the investor would need to deposit more money to cover the losses.

Note, rules around too many opening trades varies between providers.

Further Reading

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