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The Margin Investor

Margin Rate Comparisons - The make or break factor for advanced trading strategies

5/14/2012

11 Comments

 
Today's topic of conversation is margin rates, that is, the rate your broker charges you on a margin loan. The margin rate can have a profound impact on an investor's overall return and may even be the make-or-break factor in determining whether a given trading strategy will be profitable. 
To illustrate, let's consider the following example: say we have a investment strategy designed to produce average annualized returns of 5%. While 5% may sound meager to some investors, imagine that our strategy is a highly risk controlled one that hedges out most of the risk of overall market fluctuations (this could be a long/short portfolio for example). Therefore, leveraging the strategy up to 4 to 1 is both feasible and prudent. So, without margin (i.e. using leverage) the portfolio produces 5% annualized returns, but at a leverage ratio of 4 to 1, the porftfolio produces returns of 20%. 

Sounds great, no?
margin ratecomparison
Margin Rates across various on-line brokers.
Alas, the story is never so simple. The missing piece here is that we need to deduct the cost of the margin loan from the portfolio's return. So, if our margin rate is say, 6%, then we will end up incurring a negative 1% loss for any leverage we take on (since it costs us 6% to make a return of 5%). Obviously, the cost of the margin loan negates the profitability of the trading strategy.

Now this is where it becomes interesting. The most indelible shift during the past 15 years in the brokerage industry has been the emergence of discount brokers, with their constant drive towards lower costs. Generally speaking, the effect this has had on commission structures has been to drive the entire industry towards similar commissions, as well as greater transparency on commission charges. While different discount brokers have different commission schedules, they are all within a competitive range.   
What's surprising is that the same cannot be said about margin rates. There is a huge range of margin rates across different discount brokers as is illustrated in exhibit 1 below.
Margin Rates for discount brokers
Exhibit 1. Margin rates as of May 1, 2012. Source: Interactive Active Brokers website.
Exhibit 1 isn't comprehensive by any stretch of the imagination, however, it does illustrate the point. Going back to our trading strategy described earlier, only Interactive Brokers, ETrade and Fidelity charges a margin rate that would make our strategy profitable. Moreover, the strategy with Etrade and Fidelity only becomes profitable if we have an account net equity value of 1.5 million or more.

What's the lesson here? Choose your broker wisely. The margin rate can be just as important (if not more important) than commission rates, execution, technology, or service.


11 Comments
Equity Tips link
10/14/2012 02:10:55 pm

First of all let me tell you, you have got a great blog. I am interested in looking for more of such topics and would like to have further information. Hope to see the next blog soon.

Reply
Jason Apolee link
10/15/2012 06:53:37 am

Thanks! I'm glad to hear you like the blog. Let me know if there is any specific investment topic you would like me to write about.

-Jason Apolee

Reply
Tim
1/28/2013 06:35:05 am

I believe these rates are not margin rates, i.e., the portion (in %%) of the market value of purchased (on margin) securities, but just the annual interest rate the brokers charge for margin credit.

For example, if you purchase 100 shares of a stock at the price of $20 per share on your margin account, then you pay to the broker only

100 * $20 * 50% = $1000,
but not the market value 100 * $20 = $2000 of your purchase,

where 50% is the initial margin rate (for opening the position in accordance with NYSE Rule 431). The other $1000 (that you do not pay) is the margin credit given to you by your broker. For this favor, your broker charges interest rate.

For example, if this interest rate is 6% (like in your table) and this rate is simple, i.e., not compounded, then for the above purchase you have to pay to your broker $1000 * 6% * N / 365 = $60 * N / 365 if you close the position in N days (in addition to the commission of course).

The margin calculation is much more complex if your account has more than one position. For example, if you have positions in a stock and a couple of options on this stock, then this calculation is quite sophisticated. Not every broker can explain you how it is calculated without consultations with their margin department.

Reply
Jason Apolee link
1/28/2013 11:35:07 am

Hi Tim,
I think this is just a matter of semantics. In this post I was referring to the interest rate charged by a broker on a margin loan. The "margin rate" is a commonly used term to denote this concept (as are "loan rate", "borrowing rate", etc.). In contrast, "margin requirement" typically denotes the percentage of the asset value that needs to be held in the account.
Again, this is just a matter of semantics and to clarify, (and as you suspected) I did indeed mean the interest rate charged by the broker for margin loans.

Reply
Tim
1/29/2013 05:45:10 am

Thank you, Jason, for your comment. I would say that there is a terminological mess here. The term "margin rate" (since the beginnig of the last centuary at least) usually refered to the margin requirement for purchasing on margin a single unit of a financial instrument. And only recently, a lot of websites started using this term, you are right, to refer to the interest rate that brokers charge their clients for margin credit, i.e., margin loan. The term "margin rate" (in the new and wrong sense because it has nothing in common with margin requirements) appeared as a result of omitting the word "interest" in the awkward term "margin interest rate", also used everywhere in the internet. Probably the most appropriate term in this case must be the "brokerage interest rate". See e.g.

http://www.brokerage-review.com/articles/brokerage-firm-interest-rates.aspx

Can you agree with me? :-)

Jason Apolee link
1/29/2013 07:14:25 am

Hi Tim,
I agree with you that there is a terminological mess in general when it comes to trading. That said, I double checked the actual text of the Federal Reserve Reg T provision. The term "Margin Rate" is never used. So, I guess this just comes down to market convention. To avoid confusion in the future I'll try to use the term margin interest rate.
Thanks for reading!

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Learn Stock Trading link
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10/30/2013 07:07:04 am

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Amy Castillo link
12/23/2020 01:52:54 pm

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11/24/2022 09:36:02 am

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    Jason Apolee is a contributing editor to The Margin Investor where he focuses on news commentary and evaluating broker offerings.

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