For investors who trade their portfolios in a margin account, there is always the worry of what happens if your stock falls below the designated "maintenance level" for the position. When this happens a what is called a margin call follows which automatically liquidates your position and forces you to pay off any lost margin. A investor's worst nightmare is when you can't pay off the debt, ouch.
When trading any stock on margin, there are some easy ways to keep yourself safe:
- Trade with a strategy - A well disciplined strategy will not only insure you follow predefined rules but also will keep your risk of a margin call limited.
- Use stop loss orders - This is a no brainer, stop loss orders are like insurance that automatically sells your stock if it hits a price predetermined by you.
- Have a backup funding source - If the case does come where you need quick cash to pay off margin debt, you need to be ready for it. Having a back up bank account with spare funds is one way to accomplish this, otherwise you could use a cash advance loan to cover yourself until you can find backup funds.
These simple tips can keep you out of the margin call house of pain and keep your portfolio and investment future looking up.
If you are just starting off trading the best idea is to probably not use margin at all and use strict cash from your account. This guarantees you don't get yourself into any bad situations where you went out on margin to purchase a big position of a stock and it doesn't pan out the way you wanted.
When you do have a margin account you gain access to multiple trade types, and you can:
- Short stock
- Buy options
- Buy stock on margin (typically up to 2x your current cash amount)
- Short on margin (again up to 2x your current cash position)
So, if you had a $10,000 portfolio, think of margin as a loan that gives you instant access to $20,000 whenever you want it. The interest you pay on the borrowed funds is pretty competitive with most brokers, but make sure to check the rate initiating a position.
This goes back to having a strategy and staying disciplined, because for simplicity sakes let's say the interest rate is 8%, well with $10,000 borrowed cash you will have to make up the $800 in interest and then everything above and beyond is profits for you to keep.
The Bottom Line
Prepare for the worst. Don't take out margin when you are a new investor, and don't trade on margin without a strategy. Utilize stop loss orders and have a backup source of funding available just in case your instant cash reserves aren't enough to cover your losses.
Margin calls are nothing exciting and understanding them is critical to being ready for them. Trading options, shorting, and leveraging your portfolio to maximize returns are all great when you are skilled in your art. Otherwise, keep a close eye on those maintenance levels because the next call you get from your broker may not be a good one.