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We've all heard the old saying, "it takes money to make money." And that's true enough. But…
…it doesn't necessarily have to be your money.
Today I'm going to show you an advanced trading strategy that you can use to effectively "borrow" money or, as we'll see, even shares from your broker to fund the purchase of stocks and execute certain kinds of trades.
Of course I'm talking about trading "on margin." I'm going to show you how to add margin to your trading account – and your profit arsenal.
This strategy offers an advantage: You can increase your buying power to strengthen winning positions and increase your returns.
Now this is very important: The method I'm going to show you carries special risks, too. I'm going to show you exactly what those risks are, but only you can decide your risk tolerance and what's right for you.
That's just plain smart trading for any strategy.
So, let's get started…
Getting Set Up to Trade on Margin
In order to set up your account for margin, you have to at least have $2,000 in your account. This amount is what's called your "minimum margin."
Some brokerages may require more, so it's always a good idea to check with yours when you decide you're ready to start trading like this. Keep in mind your broker is required by law to get your signature in agreement to setting up your margin account; if you don't see this happen, run – don't walk – away.
Like I said, buying a stock on margin is essentially borrowing from your broker.
You can borrow up to 50% of the required capital to purchase the amount of shares of stock you want, but of course you don't have to go up to the full 50% if you don't want to.
The portion of money you put up to buy an amount of stock on margin is called your 'initial margin."
Then we come to the "maintenance margin" – the minimum account balance you have to have on hand to avoid a "margin call." That happens when your account gets too low and your broker "calls" you to require that you add more "margin" to return to maintenance margin.
This is important. If, for whatever reason, you don't have the cash needed, the brokerage can (and likely will) sell securities in your account to meet the maintenance level.
It's good to know the initial and maintenance margin requirements are set by your brokerage and the Board of Governors of the U.S. Federal Reserve through "Regulation T." The Fed hasn't changed that 50% requirement since 1974.
Here's a scenario that will show you just what margin can do for you…
How Margin Actually Works
Let's say you put $10,000 into your account. Then the brokerage signs off, and you're now all set and holding a margin account.
This now means you have buying power up to $20,000. With that $10,000 you put up, the brokerage allows you up to $10,000 more for equity and security purchases.
Now let's say you buy $8,000 worth of XYZ Widgets Co. stock. That leaves $12,000 in buying power. You don't start tapping into your margin amount until you reach the purchase of $10,000 or more of securities.
Keep in mind the buying power of your account changes daily, due to the price movement of the marginable (able to be purchased on margin) securities in your account.
There's another important point: The Federal Reserve Board, which you'll remember sets the regulations for margin, has ruled that not all stocks are marginable. Because of these regulations, and because it makes good, solid risk-management sense, it's likely that your broker will not allow micro caps or "penny stocks" or initial public offerings (IPO) to be purchased on margin.
Trading on margin is as simple and straightforward as that. So now let's look at the risks and advantages trading on margin brings…
The Risk: You Could Be Subject to a Margin Call
This is a fairly common result if the market turns against you and you have insufficient margin.
Let's say once again that you have $10,000 cash or securities, and you're allowed a further $10,000 on margin. Your maintenance margin requirement is 30%, or $3,000.
Now let's say you buy $20,000 worth of ABC Technology Inc. You put up $10,000 and your broker puts up $10,000 of margin.
But then, let's say there's a market reversal, and the value of your ABC position drops to $15,000. Your cash stash will be hit up first, so your equity then drops to $5,000.
Remember, the maintenance requirement is 30%, which means you now have to have $4,500 in cash or equivalents in the account. You're now at $5,000, so you're OK… but the numbers are getting a little tight.
On the other hand, if you had a maintenance margin requirement of 40% – which is entirely possible – and this same scenario played out, you would need equity value of $6,000, or 40% of $15,000. The account equity value is only at $5,000, so your account is now at risk of a margin call from your broker.
Bear in mind that this is essentially a loan, and you must pay interest. Sure, it may only be some small fraction of the total, but with the above scenario, you're faced with the (galling) prospect of paying interest on a losing position. It's stock, so you may be able to wait until it rebounds in price, but the thought of paying interest – a cost you won't recoup – on a losing or depreciating position might be more than you can stand.
There's another related dilemma you'll face under a margin call. You'll likely have to liquidate and sell the stocks in your portfolio. At that point, you may not be able to wait until a rebound.
Like I said, you'll have to determine for yourself whether you can withstand the "slings and arrows" of trading on margin.
When you feel it's time to try this strategy, be honest with yourself and be honest with your broker. You won't be doing yourself any favors by underestimating – intentionally or otherwise – your risk tolerance and capacity to withstand volatility.
With all that said, let's go and take a look at the undeniable trading edge you can get by trading on margin…
The Advantage: Beefier Buying Power and Superior Returns
Trader's love using "other people's money." We've even got a slang term for it: "OPM." OPM could mean reinvesting the gains on a nice 100% gain you bagged, because you've recouped your investment and you're risking only your gains – the house money.
Trading OPM could also mean using the brokerage's money on margin. Using other people's money increases your buying power, which means if you so choose, you can buy twice as many shares as you could with only your money.
And when you have twice the shares, you can make twice as much money as you might otherwise.
Let's say you want to buy 1,000 shares of JKL Industries Plc. for $20 a share.
You have $10,000 in cash and $10,000 in margin – subject to a 20% maintenance requirement, or $4,000.
You run the same risk of a reversal and margin call, but this time, the market smiles upon you… The company crushes earnings and revenue estimates and surges to $25 a share. Your position just became worth $25,000.
If you want to take your gains off the table, your brokerage gets their $10,000 back, and you certainly get your $10,000 back… with a nice $5,000 profit.
That $5,000 represents a stellar 50% profit, so you used leverage to really boost those gains.
After all, if you'd put up the entire $25,000, your gain would be just 25% – which is fine, but why take 25% when you can get 50%?
Your return on investment (ROI) is 50%, which is the $5,000 profit divided by your original capital outlay of $10,000.
That's pro trading on other people's money.
And of course, since I love to trade options, we'll talk about those, too…
A (Strong) Word About Margin and Options Trading
The Federal Reserve Board has ruled that options aren't marginable, so you can't buy them on margin.
But there's the covered call strategy, where you write calls on underlying shares you already own.
Now, it is possible to trade for those stocks on margin, and it may be tempting to write calls on those stocks for the steady income that covered calls can provide.
Here's the thing… I strongly caution you never to do it. At all.
No matter your experience and comfort level, if your brokerage institutes a margin call and liquidates those shares, you could have a serious problem on your hands…
…a naked call position. As much as I love trading, I never recommend naked calls.
That's one of the riskiest trades in the business, if not the riskiest. Your broker shouldn't let that happen – they should close the open sold calls against the stock to avoid your account ending up exposed to naked calls, especially if you're not approved to trade those.
But they're under no obligation to, and if you have a high enough options trading clearance, ending up with a naked call position is a distinct possibility.
But for stocks and other equities, trading on margin can be a solid leverage strategy if used correctly after some deep introspection.
On the other hand, it can turn against you. Make sure you're totally honest and open with yourself, and choose wisely.
Then you can act accordingly.
Tom teaches regular investors how to trade like seasoned pros twice each week in Power Profit Trades. Click here to get it for yourself at no charge, and you'll receive Tom's latest investor guide that shows you how to make a 100% profit on one of the world's biggest, most valuable companies… in less than 30 days.
About the Author
Tom Gentile is widely known as America's #1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Now, he's diving into the biggest market in the world - one that almost no one has heard of before.