Know the Rules for Using Margin

November 13, 2009

&lIf you're going to use margin, be sure you know the rules.

Margin can be a wonderful thing. It can give you enormous leverage in the markets, expanding your ability to take bigger positions and to reap bigger profits.

Margin amounts are determined by brokerages and exchanges to give you a clear indication of just how much money you can safely afford to put at risk. There are typically two margin requirements involved in a trade-the initial margin and the maintenance margin.

The initial margin is simply the percentage of the purchase price that you are required to pay in order to initiate the position. The maintenance margin is the amount you are required to have on deposit with the broker in order to keep a position open if a trade starts to turn against you.

Margin used wisely can be very beneficial if you want to see rapid growth in the value of your portfolio. But margin doesn't seem so wonderful when you find yourself tangled up in a money-losing position.

If the value of a stock you have bought on margin starts to go down, you may get a dreaded margin call from your broker, telling you that you need to add more money to your account if you want to keep your losing position open. If you don't provide any more money, the broker has the right to sell off your position.

When that kind of call comes, it's never a good feeling. In fact, the experience is a lot like looking up into your rear view mirror and seeing a blue light flashing as you are driving along, emphatically signaling you to pull over to the side of the road.

What does a margin call mean?

First of all, it is a clear indication that you have been holding a losing position too long.

Secondly, it lets you know that you're undercapitalized, that you don't have enough money to stay in the game.

Finally, it means that your market analysis and/or your money management strategy isn't working. If you had had an appropriate stop in place you wouldn't still be in the trade. But instead you've been trading with a stop at the wrong level, or without a stop in place at all. In other words, when you get a margin call you're wrong and it's time to admit it.

So what should you do when you get a margin call?

Easy. Just get out of the trade as quickly as you possibly can.

Don't look back. Don't second-guess yourself.

And don't ever put any more money into your trading account to meet the maintenance margin requirements.

Don't even think about it!

While facing a margin call is never any fun, it at least offers a sobering reminder to be more responsible in your money management.

If you need a lot of those reminders, you probably shouldn't be trading at all. Or at least you shouldn't be trading on margin!

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