The No Nonsense, Plain English Trader's Guide to Understanding Margin
Plus Cash vs. Margin Accounts, Margin Calls, PDT, Good Faith Violations, Capital Gains, Wash Sales, and Much More

This may seem like a long article. These are complex topics. I promise that taking 20 minutes to read this will save you hours of Googling and frustration later.

Understanding margin, cash vs. margin account types, margin calls, pattern day trading rules, and good faith violations can be a bit overwhelming to new and experienced traders alike. This article covers most aspects of these complex investment considerations. This is not financial advice. Always check the rules of your brokerage. In other words, if you screw up, it's not my fault.

Cash Accounts

Investment brokerages typically allow you to choose between a cash account and a margin account. You can typically change your account type later. A cash account utilizes your deposited cash for stock or other security purchases. You cannot purchase more than the balance you have on hand.

Cash accounts are often best for new traders and those that want to trade frequently with a small balance.

Cash Settlement and T+2

The T+2 rule, meaning "Transaction date plus 2 business days", can introduce complexities. On Monday morning Joe has $10,000 in cash in his brokerage cash account and purchases $8,000 in stock ABC from Mary. The $8,000 begins its slow two-day journey from Joe's account to Mary's account. Mary will receive the $8,000 before market opening on Wednesday.

On Monday afternoon Joe sells his $8,000 in stock ABC to Harry. Harry's funds will take two days to reach Joe's account and will arrive in Joe's account Wednesday morning before the markets open. Until then Joe still has $2,000 in cash on hand which he can use for other purchases.

The term "settled cash" is used to describe the amount of actual cash that an account has on hand for stock purchases. Joe's account went from $10,000 in settled cash to $2000 in settled cash when he bought ABC stock from Mary. When he sold that stock the same day to Harry, he still had $2000 in settled cash. However, his brokerage allows him to immediately utilize the full $10,000 account value for purchases on "good faith" that the $8,000 from Harry will arrive on Wednesday. The $10,000 is typically indicated by brokerages as Cash Available to Trade or Buying Power.

Because $8,000 of Joe's $10,000 in buying power is not yet received or "settled", the use of these "good faith" unsettled funds has restrictions.

Good Faith Violations

On Tuesday Joe then decides to purchase $6,000 of stock XYZ from Bob. $2,000 of the $6,000 purchase is from his settled cash (settled funds are always used first), and the remaining $4,000 is purchased using the brokerage's "good faith" or "unsettled" funds. Joe's brokerage has no problems with this and will send the $6,000 to Bob - after all, the $8,000 from Harry is expected the next morning and will more than cover that purchase amount.

Buying stock with unsettled cash IS NOT a Good Faith Violation.

If Joe decides to sell any portion of the $6,000 of XYZ before Wednesday, this sell transaction will trigger a Good Faith Violation because Joe sold stock he did not yet fully own - part of the purchase was made using unsettled funds provided by his brokerage on good faith.

A Good Faith Violation or GFV occurs when you sell stock that was purchased using unsettled funds before the funds used to buy that stock have settled.

If Joe waits until Wednesday then the $8000 from Monday's sell to Harry will be received by his brokerage - that amount will exceed the $6000 used to purchase XYZ from Bob on Tuesday, so Joe can then sell XYZ without triggering a GFV.

If Joe is unsure if he wants to hold XYZ until Wednesday, he could have instead limited his Tuesday purchase to the $2000 he had in settled funds. He could have then sold XYZ without limitation at any time.

Avoiding Good Faith Violations

Good Faith Violations only apply to cash accounts. An easy way to avoid GFVs is to never purchase more than 50% of your total account value in any one day. If Joe has $10,000 in his account and buys and sells no more than $5,000 in stock on Monday and buys and sells no more than $5,000 on Tuesday - on Wednesday he'll have Monday's $5,000 back in settled funds and can repeat this forever because he is only ever buying using settled funds.

If Joe holds any stock overnight, he'll have to keep track of when he eventually sells that stock, then wait 2 days to sell any new stock purchased using those funds in the meantime. Tracking settled cash can be difficult, so be careful!

Free-riding Violation

A free-riding violation is similar. Some brokerages allow you to purchase more than your account's value in stock on the assumption you will soon deposit funds to cover the purchase. If you sell that stock before depositing enough funds to cover the purchase, then you'll get a free-ride violation - you were free-riding for the entire transaction using funds that were not your own.

Settled Cash in Newly Created Accounts

If you have a brand new brokerage account, any funds you deposit might take a few days or a week or so to settle, though the brokerage may grant you buying power during this period. As above, you can purchase stock during this period, but selling it before your deposit settles may trigger a violation.

What happens if I get a GFV or Free-riding Violation?

While these violations sound very scary, the ramifications are really relatively minor - if you incur 3 good faith violations in a year or one free-riding violation your account will simply be limited for 90 days to making purchases using fully settled funds - something you probably should be doing anyway. In some extreme cases the brokerage may automatically sell your positions to reclaim their own money.

Margin Accounts

OK, let's move on to margin accounts. A margin account allows you to borrow funds from the brokerage to make purchases that exceed your account value. Additionally, the brokerage will allow you to use unsettled funds without the same restrictions as a cash account - no waiting 2 days for the funds from sells to settle in your account! Many brokerages require an account minimum, typically $2000, in order to utilize margin.

If Joe has $100,000 in cash in his margin account, his brokerage may lend him up to an additional $100,000 for securities purchases.

Joe can "leverage" the margin loan to potentially make more money than he could with only his $100,000 in cash. As an example, if Joe purchases stock ABC using his $100,000 in cash and ABC increases in value by 20% and Joe sells for $120,000, Joe will have made $20,000.

If Joe instead purchases $200,000 in stock ABC - $100,000 paid using his own funds and $100,000 on loan from his brokerage, if ABC increases the same 20% and Joe sells for $240,000 then repays the $100,000 loan, he will have made $40,000 - twice as much!

This can also work in reverse. If ABC instead decreases in value by 20% Joe would lose $20,000 if he used only his own cash, but would lose $40,000 (almost half of his account value!) if he used his cash AND the full margin leverage. Buying on margin comes with rewards and risks.

A primary benefit of having a margin account is that you can trade as frequently as you want (KEEP READING BELOW FOR DAY TRADING INFO) so long as you don't exceed your total buying power amount. Joe could buy and then sell $50,000 worth or even $150,000 of ABC stock 100 times in one day.

Interest on Margin Loans

Of course brokerages charge interest on the money they lend to you. Fortunately, interest is only charged on margin loan amounts that are carried overnight. This means you can utilize margin for intraday (meaning not held overnight) purchases without paying interest. Your brokerage will provide you an Available to Trade Without Margin Impact amount so you know how much you can purchase and hold over night without incurring margin interest charges.

Interest rates on margin loans vary based on many factors, but usually start around 9% annually. If Joe had $100,000 in cash and then buys and holds $150,000 in stock positions overnight, he would pay around $12.33 per night in interest on the $50,000 loan.

Joe's stock investment needs to increase in value only one thousandth of 1 percent to cover the daily interest expense!

Margin Equity

The term "equity" describes the value of something that you own. If you buy a house at a purchase price of $100,000 and put 10% down on your mortgage, your equity (the part you own) is $10,000. The loan amount (the part the bank owns) is $90,000.

For stock purchases, the amount of margin or loan available to you to borrow is based on your equity - or what you own. Most brokerages will loan up to twice your equity amount for stock purchases. This is 2 to 1 margin or leverage. If Joe's account has $100,000 in cash equity, he'll have $100,000 in available margin for a total of $200,000 in total buying power. Joe's equity is used as collateral against the potential margin loan from his brokerage.

Equity can also be comprised of owned securities. If Joe purchases $50,000 of AAPL stock, his equity remains $100,000 - he owns $50,000 in cash and $50,000 in AAPL stock. His available margin/loan amount remains $100,000. Joe can purchase up to $150,000 in additional stock ($50,000 with his remaining cash and $100,000 with available margin).

One of the MOST confusing aspects of margin accounts is that the term "margin" is sometimes used to describe the stuff that you own, sometimes used to describe the money that the brokerage will lend you, and sometimes used to describe both of these.

For clarity, I will refer to your cash or owned securities as "margin equity" - meaning the equity in your account that can be used to determine your potential margin loan amount. "Margin" usually refers to the loan amount. And the term "margin buying power" refers to the total amount of purchases you can make using your margin equity AND the margin loan.

Margin Requirements

In most cases stock purchases have a 50% initial margin equity requirement - meaning you must have equity (or ownership) in your account to cover at least 50% of the stock purchase, and if you do, the brokerage will lend you the remaining 50%.

Let's say that Joe has $100,000 in cash and purchases $100,000 of XYZ stock. The purchase was made entirely using Joe's cash. His margin equity remains $100,000. Joe owns 100% of the stock using his own funds and is not yet using his brokerage's funds.

What if Joe had instead purchased $125,000 of XYZ? He is now buying on margin using $25,000 of the brokerage's funds. Joe purchased $125,000 of XYZ, but $100,000 of this (80% of the purchase) is covered by his own margin equity. $100,000 in equity divided by the $125,000 total purchase amount is .8 or 80%. Joe is still above the 50% margin equity requirement.

What if Joe had instead purchased $200,000 of XYZ - $100,000 purchased using his margin equity and $100,000 purchased on margin? $100,000 divided by $200,000 is .5 or 50%. Joe is now exactly at 50% and cannot purchase any more without falling below the 50% margin equity requirement.

As you can see, a 50% margin requirement is just another way to describe 2:1 leverage.

Maintenance Margin Requirements

In addition to the 50% initial margin requirement, stocks also have a maintenance margin requirement - the percentage of the stock ownership that must be covered by your own margin equity after the purchase. Joe purchases $200,000 of stock XYZ which has a 45% maintenance margin requirement, so Joe must maintain full equity ownership of at least 45% of his XYZ stock.

It turns out that XYZ is a real dud and it decreases in value by 10%. Joe's $200,000 position in XYZ is now worth $180,000. He has lost $20,000 of his own money (or equity or ownership), so his margin equity is now $80,000. $80,000 divided by the $200,000 purchase price is .4 or 40%.

Margin Calls

Joe's 40% margin equity/ownership is now below the 45% maintenance margin requirement. This will likely trigger what is called a margin call or maintenance call. Joe's brokerage will demand that Joe make a deposit to bring his margin equity up to at least 45% - in this case an additional $10,000.

The brokerage may also decide to sell Joe's XYZ stock to ensure he doesn't lose more money and can pay them back the loan amount. They may restrict his ability to utilize margin or even close his account altogether. Margin calls are no fun!

Many brokerages give traders a lot of freedom to make purchases that can put them immediately in a margin call position. Joe might accidentally purchase $250,000 in stock and immediately face a very significant margin call. His brokerage assumes he knows what he's doing and that he plans to deposit sufficient cash immediately. If he instead sells the stock then he triggers a Free-ride Violation.

Exchange and House Margin Requirements

The minimum maintenance margin requirement is usually 25% (or up to 50% for short selling). This 25% is set by law and is called the Exchange Requirement. To protect themselves from risk, brokerages will typically set a higher maintenance margin requirement called the House Requirement.

The House maintenance margin requirement usually starts at a base of 30%, but can increase from there for a particular security based on MANY factors, including:

• The price of the security
• The volatility of the security
• Other security characteristics, such as price-to-earnings ratio
• Your account balance
• Your trading history
• The diversity of your account positions
• The concentration or how much of your equity is placed in one security or category of security

The maintenance requirement will not be the same for everyone and can change at the brokerage's discretion after you purchase. Changes in the stock's volatility or price, or changes to your account equity or diversity can change the House requirement, and potentially trigger an unexpected margin or maintenance call requiring you to deposit cash or sell the stock.

Some stocks have a margin requirement that is higher than the standard 50% initial margin requirement. This inherently makes the initial margin requirement at purchase the same as the maintenance margin requirement.

For example, a highly volatile stock may have an 80% margin requirement. If Joe has $100,000 in cash in his margin account, he could only purchase $125,000 worth of the stock ($125,000 / $100,000 = .8 or 80%, or calculated in reverse $100,000 / .8 = $125,000) - the brokerage will only lend him $25,000 for that risky stock purchase. If he takes that loan and the stock decreases in value at all, he may immediately be issued a margin call for falling below the 80% requirement.

Very risky stocks and penny stocks, those with a price less than $5 (or sometimes $3, depending on the brokerage), may have a 100% margin requirement. This means they cannot (or should not) be purchased using margin at all - you must cover 100% of the purchase with your margin equity. These are described as unmarginable. Joe would be limited to using his $100,000 in cash for penny stock purchases.

Most brokerages will provide a "Non-margin Buying Power" account balance to indicate the total of unmarginable securities you can purchase.

It's even possible to have margin requirements that exceed 100% or that have a $ amount per share margin equity requirement, especially for short positions or for very volatile or penny stocks.

If you choose to buy on margin, you MUST pay attention to initial and maintenance margin requirements. This can get complex if you have multiple stock positions. Most brokerages provide a margin calculator or can show the impact that a potential purchase might have on your margin availability.

Purchasing on "cash" vs "margin"

Your brokerage might allow you to purchase a stock using a "Cash" rather than "Margin" preference when buying. Some new traders incorrectly think that selecting "Margin" means they'll be borrowing the purchase amount and will have to pay interest. Instead, selecting "Margin" simply means that the purchase will be made using your cash first (if sufficient) AND that you want the purchased stock to be utilized as margin equity. Selecting "Cash" will also utilize your cash first, but the value of the stock will not be counted as margin equity, thus decreasing your margin equity (and thus your available margin amount - potentially triggering a margin call if you're carrying a margin loan) - and you'll be subject to T+2 cash settlement restrictions when you sell.

There's no good reason to purchase using the "Cash" option.

Pattern Day Trading, or PDT

While margin seems a bit scary, it can be very powerful if used responsibly. A primary advantage of a margin account over a cash account is that you can buy and sell as often as you want without worrying about the T+2 cash settlement. But there's a catch!

If you are using a US brokerage and have less than $25,000 in margin equity in a margin account, then you are limited to 3 day trades in any 5 business day rolling period. A day trade is any buy then sell, or sell then buy of the same equity in the same business day.

If you execute 4 day trades within 5 days, you will be characterized as a pattern day trader and will be required to maintain $25,000 in margin equity, or your account will become limited from day trading and/or to only using settled cash for purchases.

The PDT rule only applies to margin accounts - you can day trade all you want with a cash account! However, with a cash account you must be mindful to avoid trading violations as described above.

Being flagged as a pattern day trader can be a good thing if you have over $25,000! It allows you to close positions and sell immediately when a trade turns against you, and as often as you'd like. Additionally, brokerages will typically offer day traders additional buying power for intra-day trading - often 4:1 leverage. With $25,000 in margin equity you could have $100,000 of day trade buying power - you can purchase up to $100,000 in stocks at a time as frequently as you want, so long as you close positions so you do not exceed your Margin Buying Power (probably $50,000) when the market closes. Of course any margin loans held overnight will be subject to margin interest. And keep in mind that margin equity requirements still apply - you'd be limited to $25,000 in open positions at any time for 100% margin requirement (unmarginable) stock purchases.

Capital Gains and Trader Taxes

Before explaining wash sales, you must understand how taxable capital gains work. For US accounts, you must pay taxes on any trading profits or capital gain you earn. If you buy $5000 of ABC and sell ABC for $5000, you will have $0 in taxable gains and thus will owe no taxes on your trading activity. If you sell for $4000, you'll owe taxes on $1000.

Short term capital gains are profits made on securities held for less than one year. These are taxed at your standard tax rate - 10% if you make less than around $10,000 annually up to 37% if you make more than around $500,000 annually. Your capital gains are counted as income so (if you are successful) may bump you into a higher tax bracket.

Long term capital gains are profits made on securities held longer than one year. These are taxed at 0%, 15%, or 20% depending on your income. Holding a position for longer than one year can have a notable impact on your tax bill.

Realized gains or losses refer to your actual gains or losses after you sell sell stock. Unrealized gains or losses refer to theoretical gain or losses for open positions. You only pay taxes or can claim losses on realized gains/losses.

If you have realized losses across all of your trades in a year (meaning you lost more money than you made), then you can deduct up $3000 as a tax write off, with certain restrictions.

Wash Sales

A wash sale occurs when you buy a stock 30 days before or after having sold that stock for a loss. The wash sale rule is in place primarily to keep you from selling stock for a loss at the end of one year to decrease your capital gains and tax liability, then repurchasing the same stock again the beginning of the next year.

If you sell stock at a loss and then trigger a wash sell by purchasing within 30 days, any losses from that sell are temporarily disallowed - meaning that they temporarily cannot be used to decrease your capital gains or tax liability.

I hope you found this article helpful. If you have questions or corrections, please let me know.