Margin trading lets folks borrow securities to buy and sell more than the cash available.
But many want to know – can ETFs be purchased on margin as well? If so, how can they do it, and what are the risks?
We explain below how to use margin with exchange-traded funds in-depth.
About ETFs
Exchange-traded funds are a type of market security. They usually track either indexes or a collection of stocks.
These funds provide a low-cost option to traders who want to diversify their portfolios.
With ETFs, one doesn’t have to undergo the hassle of buying a bunch of individual stocks for this purpose.
In this aspect, they are like a mutual fund, which also pools investor money into a securities basket.
However, ETFs are different because they are traded like shares. They can be bought or sold on stock exchanges at any time.
Mutual funds are sold privately, and their net asset values change once daily.
Most exchange-traded funds are passively managed.
This is, again, quite different from mutual funds.
Many simply do nothing more than track a particular index like the S&P 500.
The expense ratios of ETFs are quite low, primarily because of their minimal management fees due to their passive nature.
Lastly, these funds are very tax efficient, and they also pass on dividends to their shareholders.
About Margin
Margin is a type of credit offered by brokerage firms to those who apply for a margin account.
It allows traders to purchase securities by borrowing money against those they already have.
Some folks also use margin for other purposes, such as a source of short-term funds.
Using margin lets an investor afford much more of a particular security than is possible through only cash.
For example, a 100% margin implies that one can buy twice as many stocks of a particular company with the same cash.
But just like any loan, the borrower must also pay margin interest.
These interest rates usually vary between brokerage firms and depend on the trade size.
Unlike other forms of debt, however, a margin account does not have a fixed repayment schedule.
An investor must maintain a required level of assets with the brokerage account to use the facility indefinitely.
Margin trading is subject to special regulatory requirements.
The Financial Industry Regulatory Authority (FINRA) sets out the rules for how much leverage can be provided by brokers.
This is because of the risks involved in using credit to trade securities.
Margin Account vs Cash Account
Two types of trading accounts can be opened with a broker: cash and margin.
The former allows only those deals made with available cash or securities.
The latter lets traders borrow shares against other securities already available to them.
As explained earlier, this lets folks buy more securities than they ordinarily can.
Stocks held in margin accounts can be lent out to other traders without notice if it goes into a negative balance.
This differs from a cash account, which is only allowed if the account holder willingly agrees.
Can You Lose More Money than You Invest in a Margin Account?
Yes, losing more than what you were trading within a margin account is possible.
Interest needs to be paid against shares bought on margin.
If the stock does not do well, the investor loses money on the trade and the interest, apart from the transaction fees and commissions.
Hence the total loss might be higher than just the cash amount available in the account.
What Cannot Be Sold on Margin?
Most securities can be sold on margin, and this includes ETFs.
However, each brokerage firm has a list of stocks that cannot be purchased this way.
Some common non-marginable securities may include penny stocks, recently held IPOs, and OTC bulletin board shares.
Investors can identify them by talking to their broker-dealer directly or checking their website.
However, these lists are not static.
As stock volatility and prices change, so do the inclusions on the list.
The idea behind having stocks that are non-marginable is to avoid risk and to keep control over the extent of trade in volatile securities.
Can ETFs Be Purchased on Margin?
Yes, ETFs work like shares and can also be purchased on margin.
FINRA governs the rules applicable to margin trades in the stock market, which also applies to ETFs.
For example, traders need to keep a minimum of 25% of the value of the margin loan in their accounts.
Moreover, the broker cannot lend more than 50% of the purchase of securities for the initial trade.
These rules apply to traditional ETFs, but for more complex funds, the rules are different.
We explain these below.
Can Leveraged ETFs Be Purchased on Margin?
The rules for margin with more complex products like leveraged ETFs, inverse ETFs, or leveraged inverse ETFs are tighter.
First, let’s quickly recap what these are:
A leveraged fund aims to amplify the returns of a normal ETF (by as much as two or three times).
An inverse ETF tries to track the same percentage movements as a traditional one but in the opposite direction.
The last variety tries to multiply returns in the opposite direction.
All three are designed on the back of derivative products. They already use borrowed money to some extent.
Margin buying in these products multiplies the leverage several times over.
This is what makes this trading strategy quite risky.
Hence, maintenance margin rules in these products are much stricter.
For example, for leveraged ETFs, 25% times the amount of leverage is the minimum requirement.
This implies that for a double-leveraged fund, 25% * 2 = 50% is required to be kept in the account.
For a triple-leveraged one, it would be 75%.
The above guideline is applicable only for long positions. For shorting, the rule is 30% instead of 25%.
Brokerages That Let You Sell on Margin
Not all brokerage firms offer margin accounts because of the risks involved.
A few that do include:
- TD Ameritrade
- Charles Schwab
- Robinhood
- Fidelity
- Tastyworks
Keep in mind that these accounts are not commission-free, unlike regular trading.
There are margin lending rates applicable for borrowing stocks, as mentioned earlier.
Investors should look for the lowest margin rates in an account.
Other features to watch out for include research and analytics capability, quality of the platform, educational features, and so on.
When Should You Exit An ETF?
To identify when to exit an ETF, traders should carefully examine four things:
- The ETF’s diversity
- Its trading volume
- Assets under management
- Risk profile
Firstly, ETFs are usually quite low-margin products. They survive by collecting a huge portfolio of assets.
Those funds that have a narrow spread of investments are inherently riskier.
Traders look at these funds as a diversification instrument. Hence such an ETF will have lower interest among folks.
Trading volume is an excellent indicator of any security’s quality, including exchange-traded funds.
Low volume indicates a lack of interest among buyers, which could signal a problem.
Assets under management are another indicator of investor trust in an ETF.
Lastly, it is important to understand the nature of their underlying securities.
Some portfolios are riskier simply due to the nature of the holdings.
It is best to study the prospectus and get an understanding of such aspects.
How Quickly Can I Sell an ETF?
ETFs are traded on stock exchanges and can be sold almost immediately during regular trading hours.
For example, the New York Stock Exchange operates between 9:30 am to 4 pm Eastern Time.
All funds and securities on the NYSE can be traded during these times.
These instruments differ from mutual funds, whose net asset value is decided only once every day.
Their prices fluctuate every second, just like stocks.
Most ETFs are fairly liquid; hence selling them is never a problem. It is even possible to make fractional trades in them.
Final Thoughts
ETFs can be bought on margin, just like securities. They carry the same risks as well.
To do this, investors need to open a margin account with their brokerage firm.
Due to the risks involved, some brokers do not offer this service.
We have listed a few that do.
There are special regulations governing margin trades, as decided by FINRA.
These pertain to the maximum possible margin available based on the risk profile of the asset class.
ETFs are generally stable, long-term investments, but they can falter too.
Investors need to understand the signs of a fund going bad and exiting at the right time.
These signals could include weak investor interest, low AUM, declining volumes, and a risky portfolio.
Tags:
