How to Use Margin Without Blowing Up
To use margin without blowing up, find your broker's maintenance requirement first and calculate what price would trigger a call. Size the position so that price is beyond any move you would accept. Leverage magnifies drawdown faster than it magnifies return.
Buying power is the number brokers display and the maintenance requirement is the number that ends accounts. This procedure works backwards from the second one and ignores the first.
Before you start
Your broker’s maintenance requirement in writing. The percentage of the position’s value your equity must stay above. It differs by instrument and the broker can raise it without much notice.
The current margin interest rate. It accrues daily on the borrowed portion whether the position moves or not, and it is quoted as an annual figure that people mentally discount.
A position size calculated from the maintenance level, not the buying power. Worked out before the order exists, because after it exists the arithmetic no longer has any influence.
The steps
1. Write down the maintenance requirement, not the buying power
Buying power tells you what the broker will lend. The maintenance requirement tells you when it gets taken back. Only the second one has consequences.
2. Calculate the price that triggers a call
Work out the exact price at which your equity falls below the requirement. Write it on the chart as a line. That price is the real stop, whatever your intended stop says.
3. Size so that price is beyond any move you would accept
If an ordinary adverse move reaches the call price, the position is too large. Reduce until the call price sits outside the range of normal movement.
4. Price the interest before you price the trade
Multiply the borrowed amount by the daily rate and by your expected holding period. A position held for months pays this every single day.
5. Account for the decay on anything held
Leveraged returns compound on a path, not on a total. The longer the hold and the choppier the path, the further the result falls behind the simple multiple.
6. Decide what you will sell before the broker decides for you
Write the order you would place if the call price is reached. A broker liquidating on your behalf picks whatever is easiest to sell, not whatever you would have chosen.
7. Check the liquidity of what you are holding
A forced sale into a thin market moves the price against the seller. Leverage on an illiquid instrument compounds the problem it was supposed to solve.
How to tell it worked
Run three checks before the order, and one after 30 days.
Check the distance to the call price in bar ranges. Divide it by the instrument’s average true range on your timeframe. If your call price is under 5 typical bars away, the position is sized for a market that does not move, which is not the market you are in.
Check the interest against the expected gain. Borrowing costs accrue every day and every round trip pays the spread, so a position needs to clear both before it clears zero.
Then, after 30 days, count the times you were within one bar of the call price. The acceptable answer is 0. Anything above that means the sizing at step three was optimistic, and the position survived on luck rather than on arithmetic.
What leverage actually does to the numbers
The plainest version of the argument is the worst fall in the S&P 500 since 1950. The index fell 56.8% from 9 October 2007 to 9 March 2009. Unleveraged, that was a brutal loss, and it was recovered by March 2013. At 2x on margin — half your own money, half borrowed — the account is erased by a 50% fall, before the index reached its low. At 3x it is erased by a 33% fall. The index figures are daily closing prices, without dividends.
Now the return side. Held at a constant multiple and reset daily, leverage falls short of its multiple whenever the path is choppy. Say the index grows 10% a year at 20% volatility: the standard approximation, L × r − (L² − L) × σ² / 2, puts a 3x position near 18% a year rather than 30%. That gap is the decay, and it comes from compounding on a path rather than on a straight line.
These are worked examples rather than a forecast, but the direction of the effect is a property of the arithmetic and holds generally: the drawdown scales more faithfully than the return does.
Here are those two lines on the actual path. The index first closed a third below its record on 7 October 2008 and half below it on 20 November 2008, more than three months before the low. The daily closes behind this chart are published.
The original data
Of the 24,971 unique videos in the search study behind this site, 18 have an instruction-shaped title mentioning margin, at a median of 28,191 views across 17 channels, with a maximum of 341,625. Leverage appears in 32 instructional titles at a median of 37,229 across 30 channels. Duplicates are removed first, so no video is counted twice.
The question: The position is down and the call is due. Add?
18 instructional videos across 17 channels is almost no coverage at all, for a mechanism that is available by default in most brokerage accounts and is a common way for accounts to end. The subject is unglamorous, which is exactly why the supply is thin and the median is high.
The answer is that adding money to meet a call is a new decision and should be judged as one. The question is not whether you want to keep the position — it is whether you would open it at this price and this size. If the answer is no, meeting the call is buying something you would not buy, funded by the fact that you already own it.
When it fails
A gap through the call price is the failure no procedure prevents. Price opens beyond the level, there was no opportunity to act between the two prints, and the position is already liquidatable before the session starts. Sizing is the only defense, because a stop cannot fill at a price that never traded — which is why step three is about size rather than about stops.
The second failure is a flat market. Interest accrues daily regardless, so a position that goes nowhere for months has still cost real money.
A third is treating buying power as a target. It is a limit on what the broker will lend, not a recommendation of how much to borrow.
A fourth is holding leveraged exposure for long periods. The decay above compounds against you the longer and choppier the path.
A fifth is leverage on an illiquid instrument. The forced sale moves the price against you at the exact moment you cannot choose the timing.
And a sixth is meeting a call by adding funds without re-examining the position. That converts a sizing error into a larger sizing error.
Related
Margin account covers what the account is and how initial and maintenance requirements differ. Leverage is the general mechanism and where the decay comes from. And drawdown is the measurement that leverage magnifies fastest, which is the whole argument on this page.
The number to look at is not the return figure, it is the drawdown one. Trebling the exposure trebles every loss, while the return, reset daily on a choppy path, falls short of trebling. The pain scales in full and the reward does not, which makes leverage a trade rather than a multiplier.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.