When should we use margin?
This fantastic question popped up today in Trader’s Mindchat!
Sounds simple enough, right?
But this question touches on soooo many parts of the game! It’s why I love it!
There’s no one right answer. How you handle margin will be determined by your:
- Trade Style
- Asset Class
- Position Sizing Strategy
- Risk Management Strategy
How I Personally Handle Margin
I use margin only when trading opportunities are abundant and I’m making progress on the trades I’ve already taken.
I’m not using margin to place bigger bets. I’m using it to place more bets.
For example, suppose I have 4 active trades. Each of them have run far enough to where I’ve raised my stops to breakeven or beyond.
A fifth and sixth trade pop on the radar! Amazing! …But all my cash is tied up in the first four trades.
Rather than exiting a trade prematurely to make room for another, I’ll use margin to take the additional trades.
Now you might be thinking “so what is this guy’s trading style? What’s he trading?”
My bread and butter is short term swing trading stocks. My average holding period ranges from a few days to a few weeks. This means that I’m dealing with overnight risk so that gets factored in.
Hold up… What’s overnight risk?
Overnight risk is this. Suppose you bought shares of AAPL at $260/share and had a stop loss down at $250. You go to sleep thinking everything is honky dory.
You wake up the next day to find something insane happened…
One of Apple’s factories blew up!
OMG! Thankfully no one was injured but Apple won’t be making iPhones anytime soon. The stock takes a bath and opens down at $230/share.
That’s an example of overnight risk and it has to be managed.
How can you manage overnight risk?
The way I do it is by looking at price charts and finding major support levels.
Take a look at this weekly chart of AAPL.
The first area of major support that jumps out at me is around $230. That correlates to both its former 2018 high as well as the current 10wk moving average.
If I’m an overnight holder of AAPL, I need to be prepared for the unlikely event that price suddenly retests that level.
How Does Each Trading Style Handle Margin?
At this point you might be thinking to yourself “Okay. That’s great for you. But I use ____ trading style. How about that?”
Day traders and Scalpers:
These guys trade extremely frequently. Some can have upwards of 100 trades per day.
They’re able to make so many trades because they’re aiming to make a very small percentage on each trade. Sometimes just a few pennies.
Part of the idea for these guys is that all those pennies will add up to dollars fast through their quick trades.
To make this work, many of them use leverage (margin) on most of their trades. They may use their full account or even go on margin on a single trade.
This may sound risky. However, because they move so quickly in and out and are not dealing with overnight risk, they may not be risking very much at all.
These guys (like me) are holding for a few days or a few weeks and have to deal with overnight risk. They’ll look at every trade in their portfolio and ask the question “What happens if these all s*** the bed at once?”
Intermediate and Long Term Position Traders
They are holding for months or years. These guys are dealing with overnight risk and asset class risk. Since they’re planning to hold for long periods, they need to ask the question, “What if the entire asset class tanks?”
intermediate and long term traders are able to stomach drawdowns. They’re willing to give back 15%, 20% or more if it means they can capture another 100% or more.
They are more concerned about fundamentals than the shorter term guys because this is where the asset class risk kicks in. Things like Trade Wars, the Fed, Brexit, etc… play a much bigger role.
And what about the asset class? How is margin different?
Margin on Stocks vs Margin on Forex
Margin on Stocks
Most stock brokers offer 2:1 margin. Some offer up to 5:1 margin.
For example, suppose you have a $5,000 account. A broker offering 5:1 margin would be willing to loan you $20,000. You’d be able to trade as though you had $25,000.
Margin on Forex
In forex, it’s not uncommon to find brokers offering 100:1 leverage. This is one of the big things that attracts traders with tiny accounts.
Take the same trader with $5,000 and give him 100x leverage. Now all of a sudden he’s trading with $500,000!
These forex traders with small accounts and dollar signs in their eyes are ticking time bombs.
What they need is the beliefs exercises discussed in “The 4-Walled Prison Of A Trader’s Mind” Otherwise they’ll blow themselves up again and again, and have a hard time understanding why.
Margin is a useful tool when used properly. Much like a power tool, there are times and places to use them.
If you want help answering the question “How much should I buy?” checkout the Trade Emotionator. It’ll also let you know if you’re being too aggressive.
Do you use margin? If so, in what ways do you use it?