Understanding Margin and Leverage in Trading

June 14, 2024 Advanced
Understand the basics of margin and leverage, along with the benefits and risks they can bring to your trades.

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.

How to access margin in a trading account

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.

Understanding exposure

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.

Use thinkorswim to evaluate a trade

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.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Backtesting results presented are hypothetical and there is no guarantee that the same strategy implemented today would produce similar results.

​Use of portfolio margin involves unique and significant risks, including increased leverage, which increases the amount of potential loss, and shortened and stricter time frames for meeting deficiencies, which increase the risk of involuntary liquidation. Client, account, and position eligibility requirements exist, and approval is not guaranteed. Carefully read the Charles Schwab & Co. Guide to Margin and the Charles Schwab & Co.  Margin Overview and Disclosure Statement for specific disclosures and more details. Charles Schwab & Co. Guide to Margin: https://www.schwab.com/resource/charles-schwab-guide-to-margin

Charles Schwab & Co.  Margin Overview and Disclosure Statement: https://www.schwab.wallst.com/pdf/activetrader/marginriskdisclosure.pdf

It is the client's obligation to evaluate the risks of portfolio margin when making investment decisions. Charles Schwab & Co. (Schwab) reserves the right at its sole discretion to decline a client the use of portfolio margin.  In the event Schwab decides to terminate a client's use of portfolio margin, the client's account may be converted to the standard margin account.  The conversion of a portfolio margin account to a margin account may require the liquidation of positions.

​The "S&P 500® Index" is a product of S&P Dow Jones Indices LLC or its affiliates ("SPDJI"), and has been licensed for use by Charles Schwab & Co., Inc. ("CS&Co."). Standard & Poor's® and S&P® are registered trademarks of Standard & Poor's Financial Services LLC ("S&P""; Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC ("Dow Jones"). Schwab Stock Slices is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, or their respective affiliates, and none of such parties make any representation regarding the advisability of using Schwab Stock Slices or investing in any security available through Schwab Stock Slices, nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.