Reminders About Margin, Part 1

Computer training

This month’s quick drop in the S&P 500 left a lot of heads spinning. Some traders were caught on the wrong side of the move, and their losses may have been magnified by the use of margin. So let’s review this practice, which has existed for years but may not be understood by all.

First, a definition: Margin involves borrowing to take positions in the market.

Second, its use: Customers can employ margin to go “long” or “short” securities — positioning for them to rise or fall.

Third, how it’s done: Brokerages must approve accounts to use margin.

Fourth, risk: If traders get the direction of an asset right, margin can leverage or enhance their gains. But if they’re wrong, losses are often magnified. Some people are even forced to pay extra money to offset bad investments. Ouch!

Fifth: Loans often have collateral. Just as a house backs a mortgage, for instance, margin accounts are secured by cash or securities.

Sixth: Aside from fees associated with using margin, brokerages also enforce rules. Traders should always know these going in. And never forget there’s a risk of losing more than your initial investment. That’s why it’s not suitable for all investors.

Ok, now applying it: You think a stock or ETF will move higher, so you “go long” in a margin account. In that case, the stock or ETF itself will provide the collateral. This is buying on margin.

Alternately, you think a stock or ETF is going to drop. So you “go short,” borrowing the security to sell it now in hope of buying it  back lower in the future date. In that case, cash held in your account serves as collateral. This is selling on margin.

Next time, we’ll take a deeper look at the mechanics of these transactions.