Trading on margin is a common strategy employed in the financial world; however, it is a risky one. Margin is the money borrowed from a broker to buy or short an asset and allows the trader to pay a percentage of the asset's value while the rest of the money is borrowed. Like any form of borrowed money, interest is incurred.
Trading on Margin
Trading on margin makes it easier for traders to enter into trading opportunities as they don't have to be concerned about a large outlay of cash to acquire an asset.
Margin interest is the interest that is due on loans made between you and your broker concerning your portfolio's assets. For instance, if you short sell a stock, you must first borrow it on margin and then sell it to a buyer. Or, if you purchase on margin, you will be offered the ability to leverage your money to purchase more shares than the cash you outlay.
For example, with a 10% margin, you may buy $1,000 worth of shares while putting up just $100. That extra $900 is granted to you in the form of a margin loan, for which you will have to pay interest. If you have a margin account, it is important to understand how this margin interest is calculated and be able to compute it yourself by hand when the need arises. It's just as important as the interest on your savings account.
Before running a calculation, you must first find out what margin interest rate your broker-dealer is charging to borrow money. The broker should be able to answer this question. Alternatively, the firm's website may be a valuable source for this information, as should account confirmation statements and/or monthly and quarterly account statements.
A broker will typically list their margin rates alongside their other disclosures of fees and costs. Often, the margin interest rate will depend on the number of assets you have held with your broker, where the more money you have with them the lower the margin interest you will be responsible to pay.
Margin Interest Calculation
Once the margin interest rate being charged is known, grab a pencil, a piece of paper, and a calculator and you will be ready to figure out the total cost of the margin interest owed. Here is a hypothetical example:
Suppose you want to borrow $30,000 to buy a stock that you intend to hold for a period of 10 days where the margin interest rate is 6% annually.
In order to calculate the cost of borrowing, first, take the amount of money being borrowed and multiply it by the rate being charged:
- $30,000 x .06 (6%) = $1,800
Then take the resulting number and divide it by the number of days in a year. The brokerage industry typically uses 360 days and not the expected 365 days.
- $1,800 / 360 = 5
Next, multiply this number by the total number of days you have borrowed, or expect to borrow, the money on margin:
- 5 x 10 = $50
Using this example, it will cost you $50 in margin interest to borrow $30,000 for 10 days.
While margin can be used to amplify profits in the case that a stock goes up and you make a leveraged purchase, it can also magnify losses if the price of your investment drops, resulting in a margin call, or the requirement to add more cash to your account to cover those paper losses.
Remember that whether or not you gain or lose on a trade, you will still owe the same margin interest that was calculated on the original transaction.
The Bottom Line
Trading on margin is a risky business, but can be profitable if managed properly, and more importantly, if a trader does not overleverage themself. It also makes accessing certain asset values easier as a trader doesn't need to put up the total cost of an asset when they see an interesting trading opportunity. When entering a trade on margin, it's important to calculate the borrowing cost to determine what the true cost of the trade will be, which will accurately depict the profit or loss.