Understanding Margin and Leverage in Trading

Margin and leverage offer traders the opportunity to establish a position in larger valued assets than they have cash for. However, when trading using margin, it's important for traders to understand that unexpected market movements can cause both large gains and losses in leveraged trading strategies when compared to unleveraged positions.

Before buying securities on margin, approved margin traders must sign a margin agreement that allows them to borrow money from the broker to buy securities. Then, they use the securities as collateral. Borrowers must pay interest while this loan is outstanding.

One potential advantage of trading with margin is investors are only required to deposit a percentage of market value of the securities. This financial leverage can help provide some flexibility in traders' portfolios, as well as potentially increasing their return on investment. However, in exchange for a potential increased return, there's an increased risk for magnified losses. The money a qualified trader must deposit for margin trading is governed by the Federal Reserve and other regulatory organizations such as FINRA.

Brokers may require a higher percentage margin requirement based on the risk profile of the security or sector at any time without notification. Additionally, the margin requirement is not always the maximum amount borrowers can lose, so the broker also requires clients to keep a minimum account maintenance margin.

If price fluctuations cause margin equity to fall below the house minimum, the broker can close out the client's positions, which means the client can lose more funds than they deposited in a margin account. Typically, brokers first issue a margin call to give the client a chance to deposit additional funds. However, brokers are not required to inform clients when their accounts fall below the firm's maintenance requirement. Under most margin agreements, even if the firm offers to give clients time to increase the equity in an account, the broker can sell the client's securities without waiting for them to meet the margin call.

Exposure is the risk of the investment and amount the trader stands to lose. Two risk measurements used to calculate market exposure and financial risk include expected price range (EPR) and point of no return (PNR).  When it comes to EPR, traders should consider what they believe are the most likely expected ranges a security might exhibit and be prepared to react should their expectations not be met.

EPR is the largest expected single-day move based on the security's history; factor in anywhere from three to five years of historical price data, as well as big momentum event days.

EPR helps investors estimate if their portfolio has enough cushion to absorb tail risk or outlier moves.

PNR represents the percentage move the security would have to make, based on your direction of risk, before you would lose your entire account value. It takes into account losses from a single position (idiosyncratic) compared to the investor equity.  It's designed to calculate at what percentage the underlying price causes the account to become unsecured. Simply put, this percentage represents how much of a price move your equity can support before your account value goes to zero. Ideally, the expected price range should always be higher than point of no return.

Traders and investors can access historical daily prices of securities on thinkorswim^® charts. Use the Scan tab to turn on the thinkback^™ function, which allows users to view past pricing and past implied volatility.

The Analyze tab allows users to review simulated or existing trades and positions using standard industry option pricing models.

It's also possible to beta weight positions based on a benchmark, including the S&P 500^® index (SPX). Beta weighting, simply, is the process of comparing volatility of a security with a broader benchmark. With the help of thinkorswim, it's possible to calculate percentage up or down to estimate the theoretical gains or losses on the portfolio and evaluate how exposure to leveraged positions could potentially impact overall performance.