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Retail investors are in love with leverage. In June, margin debt hit a record high of $1.5 trillion, up 49% from a year ago, according to the Financial Industry Regulatory Authority. Experts say that the rise in leverage is amplifying volatility in retail-favorite stocks and heightening the risk of forced selloffs.
Margin lets investors borrow money from their brokerage to buy more stocks than they could with cash alone. It’s one of the most popular forms of leverage, alongside options trading and leveraged exchange-traded funds.
The appeal of margin is its ability to enhance returns, but the same leverage that boosts gains also deepen losses. When markets turn lower, investors using borrowed money can face margin calls, requiring them to either add cash or sell positions at unfavorable prices.
A Dot-Com era rule previously restricted margin access for high-frequency traders to those with account balances of $25,000 or more. Last month, a new margin framework replaced the 25-year-old pattern day trader rule.
Under the new intraday margin rule, retail traders can now execute unlimited day trades on margin with account balances as low as $2,000, granting smaller, less capitalized accounts greater access to leverage. Although the rule removes formal limits on day trades, it continues to limit how much margin traders can access relative to their account collateral.
Investors have largely celebrated the rule change, which allows them to enter and exit trades without concern of having their account flagged for day trading.
“The $25,000 PDT requirement has been more harmful than helpful in my personal experience,” one investor wrote in a comment to the SEC earlier this year. ”There have been situations where I needed to exit a trade to protect myself from loss, but hesitated because I didn’t want to be flagged as a Pattern Day Trader. In one particular case, that hesitation forced me to hold a position longer than I should have, which resulted in a significant financial loss.”
Still, experts say that granting easier margin access to smaller traders could leave them vulnerable to sharper downturns.
The extent of that vulnerability is reflected in net credit balance, which tracks how much margin debt investors carry relative to the cash in their brokerage accounts, according to RIA Advisors Chief Investment Strategist Lance Roberts.
Roberts warns that traders operating with only a few thousand dollars in their accounts may have fewer resources to meet margin calls, increasing the risk of forced selling during market declines. That vulnerability is growing as volatility rises across many heavily traded retail stocks, where sharp price moves can make margin calls more likely.
Average volatility across a basket of 20 popular retail stocks has increased by 80% since the new margin rule took effect, relative to the same period last year. Even in tickers where institutions own a vast majority of the outstanding shares, experts say relatively small, leveraged traders can create major swings in the price.
Stocks including Micron Technology, Sandisk, and AST Spacemobile, which have gained popularity among retail traders on forums like Reddit’s WallStreetBets, have experienced sizable increases in volatility over recent weeks.
Interactive Brokers Chief Strategist Steve Sosnick says that brokerages will try to limit volatility in particularly frothy stocks by raising margin maintenance requirements. Brokerage platforms impose a 25% minimum equity requirement for eligible margin securities, but impose stricter requirements on individual stocks. In effect, higher maintenance requirements curb borrowing by forcing investors to put up more cash, reducing leverage and potential volatility.
“We can and do adjust our initial and maintenance margin requirements on specific stocks from time to time based on volatility and other factors,” Sosnick says. “And I know we’re not alone in that.”
But effectively limiting margin isn’t simple. In rapidly rising stocks, efforts to rein in margin speculation can have an unintended consequence: by reducing leverage, they may weaken a key driver of demand and accelerate a market correction, Roberts says.
“We saw the same thing last year with Silver,” Roberts says. “The COMEX [Commodity Exchange] kept hiking margin requirements to break the speculation, and the price eventually reversed.”
Brokerage platforms like Robinhood and Webull, popular among younger investors, say the new margin rule is a win for investors.
In a letter to the SEC earlier this year, Robinhood President Matt Billings wrote that under the previous rule small investors traded less frequently than they otherwise would to avoid being subject to pattern day trader restrictions.
Webull CEO Anthony Denier said during the company’s first-quarter earnings call in May that he expects the elimination of the pattern day trader rule to eventually boost trading volume by at least 20%.
Critics say that many small retail investors lack the necessary knowledge to effectively use margin.
“I think the passage of the rule was terribly short-sighted…Honestly, if you’ve only got $2,500 invested in the markets, you’ve got no business buying margin,” Roberts says. “I think they should have increased the limits to use margin, not reduce them.”
A Finra spokesperson said the new rule eliminates the $25,000 minimum equity requirement for day trading in a margin account, but doesn’t change the existing $2,000 minimum equity requirement to open and use a margin account.
Before the SEC finalized the rule, NASAA President Marni Rock Gibson wrote in a comment letter that the proposal was “not consistent with investor protection and the public interest.”
“Even in a zero-commission environment, smaller, less experienced traders lose money due to a variety of factors, such as overconfidence in their information and abilities, volatility, and the reality that other market participants are better equipped to seize profitable trades and liquidity in fractions of a second,” Gibson wrote.
Write to Elijah Nicholson-Messmer at [email protected]