What Is Margin?
(Last Updated On: 10. April 2023)
The concept of margin is a very important one every trader (albeit an options trader or futures trader) has to deal with. It’s even such crucial for you to understand this topic that you should know that even some well-known professional traders got victims of their own rashness because they got into trouble with the margin. As a result, they went bankrupt. In this article, I’ll give a rough overview of the concept of the margin. So read on, folks.
What Is Margin And How Does It Work?
So what is meant by a margin in trading? To explain this, we should start with an explanation of the types of trading accounts.
Imagine you would like to open a trading account. In this case, you usually can decide between two types of accounts – a cash account, and a margin account. With a cash account, you can trade as much as you paid in your trading account. With a margin account on the other side, you can trade much more than your account size allows it. And this is actually a common type of trading account – a margin account.
The advantage of a margin account is that, as mentioned, you can open much more trades than your real account balance would allow it. The disadvantage of a margin account is that this type of account invites to exaggeration, and here is the crux of the matter.
Many trading beginners and even professionals disregard this fact and open too many trades. This works fine as long as things are working well. But as soon as things start to go wrong, you would get a lot of problems which all begin with a “scary” term “margin call”.
Nobody wants to get a margin call. If you get one, you will know that you screwed it up! And nowadays, a margin call is even worse than 20 years ago. More about margin calls, you will find in one of the sections below. But now, let’s continue with the question of what is margin and what is it good for.
So finally, what is margin, and how does margin work? A margin is a kind of security deposit. When you open a trade, a part of the money you have in your account gets automatically frozen as long as you’re in the trade. When you close the trade, the money will be unfrozen immediately. Actually, that’s the whole concept of what margin is and how it works. As you can see, it’s a pretty simple concept to understand.
What Is Margin Good For?
Actually, a margin is good for both sides – for you and for your broker. It’s good for your broker because your broker is accountable for your losses. Why? Because a broker has to ensure the counterpart of your trade gets the money once things go wrong. If you will not be able to pay your dues, your broker will do it for you.
And here’s the catch. Your broker doesn’t want to pay your dues which is understandable because he wants to make money and not to lose it. Therefore, to cover himself against potential losses, your broker freezes a part of your money. This is the money he would take if you wouldn’t be able to discharge your payment obligations.
But this is just the beginning of the story. The money you got frozen up is not all the money you would “lose”, but you need to pay more. Your broker (once things would go wrong) would try to get as much of your money as possible. How he would do this, you will learn in the section about the margin call, folks.
When you read these lines, it seems your broker is the only one who profits from the margin concept. But the truth is that you benefit from this as well, even if it doesn’t seem this way. The reason it’s good for you is that with a margin call, the broker would prevent you from a total failure of your account, of its complete collapse if you will.
What Is Margin Call?
When you open a trade, your broker will freeze up a certain amount of your money, called the initial margin. That’s the money your broker secures to get at least a bit of safety. But in case things start to go wrong, your broker starts to freeze up more and more of your available money. All of this is to make sure you’ll be able to cover your losses. But once it gets clear the size of your money account wouldn’t be sufficient, you would get a so-called margin call. But what is a margin call?
Well, before the era of electronic trading, when people traded on the floor, you would indeed get a call from your broker. And he would say something like: “You are reaching the maximum of your allowed margin. Please send over more money or reduce your positions.” If you wouldn’t do this, you would get another call the next day. And if you would have known him well, maybe one more on the third day. But those days are gone, and what remained is the just name “margin call”.
Nowadays, you wouldn’t get a call at all because we live in a trading environment of algorithms scanning accounts in real time. As soon as you cross your allowed margin level by just one cent, the algorithm starts to close your positions regardless if they are in the loss or win zone! That’s why you must have good money management to avoid a margin call.
How Is Margin Calculated, And How Much Margin Is Safe?
The margin is calculated based on the risk the exchange is presuming when you open the trade. This risk is the worst case an exchange is calculating with. But what is the worst case? If you have read my article about implied volatility, you have learned the concept of standard deviations. If not, I recommend you either read this article or check other sources about standard deviations so you can follow my explanations, folks.
But anyway, the exchange calculates the margin on the risk basis of two standard deviations. With two standard deviations, the exchange ensures that when you open a trade, and afterward, the stock (or a futures contract) makes a strong move, the exchange will get the money which results in a loss from this move.
The next day, the margin will be reevaluated by your broker. The broker will take a look at the move of the stock or other security you opened an options trade on, and then he will recalculate the two standard deviations. After this, your margin will be adopted to the move of the security. Of course, there exist a lot of different strategies in the markets on how to reduce the margin and even how to keep it unchanged. The classic ones are ,for example, the bull-put spread or cash-secured put.
This was a pretty simplified explanation of how the margin is calculated. But I hope this explanation will give you a rough understanding of the calculation of the margin.
But how high should your margin be, and how much margin is safe? Well, there are a lot of different recommendations and opinions. But if you ask me, they are all subjective. Some traders recommend using a maximum of 20% to 30% of your account size. My personal recommendation, and it’s also a recommendation of other professional traders I know, is to have a total margin of a maximum 50%. After a crash, when you see that the markets start to recover, then (and only then) you can temporarily deviate from this rule and increase the margin to 70% to profit from the fast market recovery. By the way, if you would like to know how to profit from crashes in the stock market, you should check my course on Udemy, folks.
As you can see, every trader is acting differently which is absolutely legitimate. The reason for this is that every trader has his own trading strategy and a certain account size. Therefore, it’s actually not possible to give an objective answer on how much margin is safe.
But whatever you do, just ensure you have enough money to avoid a margin call. Always check your available money (which is not frozen up) and check your positions before adding new ones. Always ask yourself: how much would you risk when you push up the margin, and can you afford it to do this?
In other words, it’s all up to you how you deal with this topic. As long as you have good money management, you can deal with the margin as you want.
Is Margin Trading A Good Idea?
If you ask yourself: “Is margin trading a good idea”, I can say: yes, it is. But again, as long as you follow the rule not to exaggerate, and as long as you have good money management. If you deviate from the rule and disregard the margin, you will risk losing a bigger part of your money or even your whole account. In this case, margin trading would be a bad idea. And to show you that even professionals make these mistakes, I’d like to give you one example of when a professional went bankrupt because this person didn’t care about the margin.
Karen “Supertrader” Bruton
There is a lot of information about Karen Bruton on the internet and on YouTube available. But a lot of this information I cannot verify if this information is fake news or not. Therefore, I cannot give you detailed information about Karen Bruton without risking providing false information.
Therefore, long story short of some reliable sources:
Karen Bruton’s trading activity began somewhere at the beginning of the 2000s. Allegedly, she had $100.000 and would borrow money from her family. In total, she would have about $600.000 at the beginning, and she would develop a strategy for how to trade options on indices in the stock markets, like options on index ETFs like the ETF on S&P500 (SPY), on Russel 2000 (IWM), and so on.
The incredible result was that she would take these $600.000 and make $40 Million in just three years, which means an annual result of around 305%. Because of this success, she set up a fund and gathered more money, for example, from institutional investors.
As a strategy, she specialized in trading strangles on these products. If you never heard about a strangle: a strangle means that you sell a naked put and a naked call at the same time. The idea behind this strategy is to speculate that the underlying (stock, futures contract, or whatever) will move sideways. If the underlying starts to move in a certain direction and cause losses, you would need to adjust your positions by closing the loss positions and opening new positions with a longer expiration than the previous position to recover the losses. The term for this method is called “rolling positions”.
According to the available information, she wouldn’t roll the positions into a longer period of expiration. Instead, she would select a lower strike with the same expiration. But to collect a premium to recover the losses and generate a profit, she would need to increase the number of positions.
But the problem here, as you might already recognize, was what? Correct, bigger positions mean a higher margin. And by using this method, she must have had her account operating under full load and thus the most time at the margin limit.
Doing this, it would be just a matter of time before an account operating at margin limits would get a margin call. And in one of the interviews I’ve seen, she admitted to realizing a loss of $50 million on just one freaking day!
But it seems that she tried to conceal this huge loss of $50 million, and did some actions to generate incentive fees, although she didn’t make profits at all. These actions lead to a fraud investigation by the SEC. But to explain it all in detail would go far beyond the scope of this article, and it’s actually not the core topic of it. If you would like to read the SEC allegation, you can download it here. What is important to learn from this case is to have very good money and risk management. Just in case you are looking for a good book about risk in trading, I can recommend the book called “Trading Risk by Kenneth L. Grant”*
Okay, folks, this was one example to show you what happens when you operate your account at the margin limit. There are, of course, more examples with professionals. If you would like to read more about it, just google Victor Niederhoffer. It’s a hedge fund manager (actually a brilliant one) who exaggerated it twice.
As you can see, having good risk management and dealing with margin properly is crucial to surviving in trading!
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