Introduction: Margin and Leverage
Trading on margin is about managing risk. Imagine Harry wants to buy a home. He has $50,000 in cash and receives a loan of $50,000 to buy a house for $100,000. Then, in a year he sells the home for $500,000. By leveraging himself to enter the real estate market, Harry substantially increased his investment return. While Harry just enjoyed greater gains, he also risked greater losses had the investment not worked in his favor.
The most commonly understood definition of trading on margin is borrowing cash to buy securities. Leverage is what gives you the ability to increase your buying power in the marketplace.Leverage is usually expressed as a ratio.
Securities vs. Commodities Margin
There are two definitions of margin in the United States depending on if you are trading securities or commodities, and the margin related to each product is somewhat different. When you buy a security on margin you’re borrowing cash to increase your purchasing power. However, when you buy a commodities contract on margin, you’re actually putting up collateral to support the value and risk of the investment vehicle.
The Securities Exchange Act of 1934 granted power to regulate credit for the purchase of securities to the
Federal Reserve Board (the FRB or the Fed). The SEC is charged with enforcing the rules established by the Fed.
The Commodity Futures Trading Commission Act of 1974 created the CFTC to replace the U.S. Department of
Agriculture’s Commodity Exchange Authority as the independent federal agency responsible for regulating
commodity futures and futures options markets in the United States.
Margin models determine the type of accounts you open and the type of financial instruments you may trade.
Trading on margin uses two key methodologies: rules-based and risk-based margin.
- In rules-based margin systems, your margin obligations are calculated by a defined formula and applied to each marginable product. This is the more common type of margin strategy used by securities traders.
- In risk-based margin systems, margin calculations are based on the risk inherent in your trading portfolio. The positions in your account are evaluated against one another and, based on their risk profile, used to create your margin requirements.
Rules Model – Reg. T: The U.S. central bank, the Federal Reserve Board, is responsible for maintaining the stability of the financial system and containing systemic risk that may arise in financial markets. It does this, in part, by governing the amount of credit that broker dealers may extend to customers who borrow money to buy securities on margin.
Portfolio Margin (TIMS) – The Theoretical Intermarket Margin System, or TIMS, is a risk-based methodology created by the Options Clearing Corporation (OCC) which computes the value of the portfolio given a series of hypothetical market scenarios in which price changes are assumed and positions revalued based on those changes.
SPAN – Standard Portfolio Analysis of Risk, or SPAN, is a risk-based margin methodology created by the Chicago
Mercantile Exchange (CME) that is designed for futures and futures options.
- Cash – The default permission granted to traders who are not approved for margin trading. All transactions must be paid in full. Borrowing cash to complete a transaction and short sales are not allowed.
- Reg T Margin – This permission is based on the rules-based model governed by the Fed. This account type allows you to borrow cash to complete a transaction, as well as to conduct short sales, so long as all activity complies with the regulatory restrictions of Regulation T.
- Portfolio Margin – This permission is based on the risk-based margin model. The risk is assessed holistically based on the contents of your portfolio and determines the buying power and margin requirements.
Shorting a stock is selling a stock you do not currently own. This is a transaction in which you borrow the shares
then buy them back at a later date, hoping to profit from the decline in share price. Shorting can only be done within a margin account.
- For margin trading of securities, initial margin is the percentage of the purchase price of the securities that the investor must have in their account.
- Maintenance margin is the minimum amount of equity that must be maintained in a margin account.
- At IB, for Reg T margin purchases, you generally are required to have a minimum of 50% of the purchase price of the securities in the account by the end of trading on the day of the purchase. This amount is set by the Fed within Regulation T. However brokers may have greater in-house requirements.
- In accordance with US regulations, the minimum maintenance margin requirement for a long stock position is twenty-five percent of the value of the shares.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Supporting documentation for any claims and statistical information will be provided upon request.
Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.
Disclosure: Margin Trading
Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.
For additional information regarding margin loan rates, see ibkr.com/interest