Are you considering utilizing margin to trade, or are you already using it? If so, there are a few key things you need to know—including how margin debt protection (MDP) works. Here's a closer look at MDP and who it may be appropriate for.
What is margin?
Let's start with the basics. A margin loan allows you to borrow against the value of investments you already own. It's an interest-bearing loan that can be used to access funds for a variety of reasons, such as using the value of your existing positions as collateral for a loan to buy more stock.
Margin is generally used to potentially enhance returns by increasing an investor's capacity to buy assets—for example, to buy more stock than the cash you have on hand. As a result, margin can both potentially enhance returns and increase the risk of higher losses.
An example may help illuminate what margin entails. Assume you bought a stock for $20 and it increases to $25. If you bought the stock with cash at $20 and sold it at $25, you made a 25% return (excluding trading costs and taxes). If instead you had bought the stock on margin paying $10 in cash and borrowing $10 from your broker using margin, and you sold the stock when it increased to $25, you would earn a 150% return. Of course, you still need to pay back the $10 you borrowed, plus any interest that accrued during the margin loan.
On the flip side, if the stock you bought with cash at $20 fell to $15, you would have lost 25% of your investment and must also pay the margin interest you owe. If you purchased the stock on margin, paying $10 in cash and borrowing $10 from your broker using margin, you would have had a 50% loss and must also pay the margin interest you owe.
Margin debit protection up close
With margin basics in hand, let's take a closer look at margin debit protection—a margin account feature that can help ensure you don't accidentally place a trade that exceeds your available cash.
The primary advantage of MDP is that it can help you actively trade and avoid cash trading violations. Only collected cash or settled proceeds of fully paid-for securities qualify as "settled funds." MDP allows for trading on unsettled funds without having to worry about trading violations like "good faith violations" (see sidebar).
Of course, even with margin debt protection, there are still some scenarios where you could incur a debit balance. For example, if you make a deposit and it "bounces" after trading on the funds, or if you transfer in a debt from another firm. Margin debt protection simply helps ensure that you don't place a trade that may directly cause a debit.
What is a good faith violation?
A good faith violation occurs when you buy an investment and sell it before paying for the initial purchase with settled funds in a cash account. Liquidating a position before it was ever paid for with settled funds is considered a "good faith violation" because no good faith effort was made to deposit additional cash into the account prior to settlement date.
Enabling margin debt protection
When MDP is enabled, margin requirements in the account will be set to 100%, eliminating available leverage. If you attempt to buy a security that exceeds your balance available to trade, you will receive an error message letting you know that the account cannot support this trade.
Here's how you can enable and disable MDP at Fidelity:
Enabling MDP . You can turn MDP on and off using the Features page on Fidelity.com, Fidelity Mobile® App, and Active Trader Pro®. MDP can be turned on as long as the account meets these requirements:
- Account is eligible for margin (or already has it enabled).
- Account does not have a debit balance.
- Account does not have options Tier 2 or higher. (Note: If you apply for Tier 2 with MDP enabled, you will be informed that this options level requires the full margin capability and by applying for this level of options, you are also turning off MDP.)
- Account does not hold a short equity position.
- MDP was not disabled previously on the same day.
Disabling MDP . You can disable MDP, which removes debt protection, but it's important to note that this does not remove the margin feature. Like enabling MDP, disabling MDP can also be accomplished through the Features page. Disabling MDP returns the account to a full margin account with normal margin requirements, normal margin balance views, and the ability to trade using margin. Disabling MDP can occur at any time, but reenabling cannot occur until the next business day.
Investing implications
Is enabling margin debt protection right for your strategy? If you trade using margin, or are considering using margin, you may want to learn more about MDP. Depending on your objectives, it may help you trade and avoid violations that could put a hitch in your plans.