Margin Trading, Risks and Rewards, Buying Power (Excess Equity)

Buying on margin is a common investment technique involving the possibility of purchasing securities on credit from a brokerage. Such leverage allows investors to increases their purchasing portfolio’s utility and may lead to higher revenue generation. But like all things, margin trading is not without its risk and this is why learning how it operates is vital for application of this strategy. In this article, we shall also discuss margin trading, how it works, its risks and returns, buying power or excess equity and instances where it can be applied.

 

What is Buying on Margin?

Buying on margin is where an individual obtains credit from a brokerage firm to finance the purchase of shares, debentures or any other securities. The securities mobilized here work as a security for the credit advanced. Margin trading requires investors to open a margin account with their broker to access funds for trading. The initial amount invested is used to meet a margin requirement, and the brokers funds the balance that is required to carry out the purchase.

 

Key Features:

• Leverage: Increases potential of gains and losses.
• Interest Costs: Loan money comes at a cost in the way of interest rates.
• Margin Requirements: There is a lower amount that an investor should keep in his or her account called the maintenance margin.

 

Margin and Margin Trading: How It’s Done

1. Opening a Margin Account

• First of all, an investor must have a margin account with a brokerage firm before start margin trading. Unlike a basic cash account, this account operates as a traditional account in that it may borrow money.

2. Margin Requirement: Everything You Need to Know

• Initial Margin Requirement: The minimum proportion of the acquisition price that an investor must put up in his stock before he can borrow the balance from his broker. Usually, it is equal to the ½ of the price at which the equipment was purchased.
• Maintenance Margin: The amount of money on the account that has to be kept after the purchase, commonly accounts for 25% of the total cost of the stock.

3. Placing a Margin Trade

• The investor decides on which stock or asset he is going to invest in.
• Finally, the investors acquire the asset with equal contributions of their own money (50% asset) and a 50 % equity loan.
• For instance, if an investor wishes to purchase equities worth fifty thousand dollars, they can invest twenty-five thousand dollars out of their pocket and the rest from the broker on margin.

4. Monitoring Margin Calls

• Anytime the value of the securities in a margin account falls below maintenance margin, brokers raise what is referred to as margin call. The investor must contribute other cash or margins or sell other securities in order to meet the required margin.

 

Margin Trading: Risk Involved and Benefits to Be Derived

Rewards

• Increased Buying Power: Gearing enable investors to control more exposure with less amount of capital.
• Potential for Higher Returns: Profits increase on the borrowed amount.
• Flexibility: The, stock holders or investors can possibly get more securities in an effort to balance risk.

Risks

• Amplified Losses: As with any tool that can be used to increase the benefits one may also reap the costs with the same ratio. That is, if you chose a small Price Point Cut you were likely to make substantial losses.
• Margin Calls: Holding account below maintenance margin will force the investors deposit more money or else sell some of the stocks.
• Interest Costs: Loan money earns interest and is thus always costly for a business or firm in terms of the profit margin.
• Market Volatility: Large and sharp fluctuations can cause margin equity in a trading account to dwindle very fast.

 

Buying Power (Excess Equity)

What is Buying Power?

• Buying power is the total purchasing capability of an investor in securities that is the sum of his/her invested money and borrowed money on margin.

Excess Equity

• Market equity is the equity in a margin account above the specified minimum amount. It helps to protect from margin calls, and also may increase buying capacity.

Formula:

• Buying Power = Equity in Account × 2 (provided that the first margin is 50% of the account).

Example

• An investor has five thousand bucks in the margin account initially as an investment tool.
• They can get $10,000 on a second mortgage.
• Their total buying power is 20000$.
• If the value of their holding rises, the excess in equity also rises, improving their purchasing ability even more.

 

Examples of Margin Trading

Example 1: Successful Margin Trade

• An investor has funds of $5,000 on their margin account.
• In this case they use $5,000 to make a purchase of $10,000 worth of stocks on the market.
• The stock’s value raises by this percentage to $12000.
• So, after paying off the loan and the dividends, equity is $7,000, which is four times the amount of the initial investment, with 40 percent return on investment.

Example 2: Losses on Margin Trade

• An investor invests $5,000 which includes his own cash and takes $5,000 from a bank to acquire $10,000 of stocks.
• The price of stock decreases to $8,000 decreasing to its current price by 20%.
• After the $5000 loan has been paid back there is only $3000 left in the portfolio which is a loss of 40% on the investors stake.

Example 3: Margin Call

• An investor initially owns $6,000 of equity, and purchases $10,000 of securities by putting $4,000 of his own money and then borrowing the balance.
• The stocks decrease to $8000 meaning that the account equity of $4000.
• The maintenance margin requirement is 25%, or $2,000.
• The broker sends a margin call, demanding the investor brings $1 000 into the trading account margin call.

 

Limitations of Margin Trading

• High Risk: Leveraged can be dangerous and result in the total loss of capital put down as deposit.
• Interest Costs: Relative advantages of borrowing outweigh the benefits especially when borrowing it in uncertain markets.
• Margin Calls: Swings in tactical directions can lead to margin calls, which make investors to sell their products at dumped prices.
• Limited Control: When, for instance, the margin requirement is violated, the brokers can close the position without the client’s permission.

Margin Trading vs. Other Investment Strategies

Margin Trading Vs Cash Trading

• Cash Trading: There is no funding from outside sources like banks, no interest cost and no margin call to equity investors.
• Margin Trading: Utilizes borrowed money, the resultant profit and loss is also magnified.

Margin Trading Vs Option Trading

• Margin Trading: Specializes in borrowings to purchase securities.
• Options Trading: Refers to contracts that involve the right to purchase in a particular price or sell at that price.

Margin Trading Vs Futures Trading

• Margin Trading: Directly involves securities.
• Futures Trading: In regards to contracts for purchase/sale on futures price changes.

 

Possible Methods of Reducing Risk in A Margin Trading Activity

• Set Stop-Loss Orders: Automatically sell positions to cut down the losses.
• Diversify Portfolio: You should also diversify by investing your funds into different fields to minimized the bad chances of getting affected by risks.
• Avoid Over-Leveraging: One should only borrow as much as you can afford to be comfortable with or better still avoid borrowing at all cost.
• Monitor Positions Regularly: Keep abreast with movements of the market and the account equity.
• Understand the Costs: Remember to pay attention to rates of interest, as well as margin calls.

 

Conclusion

The use of buying on margin presents other ways of increasing return on the stock through leverage but have high risks. Through realizing how this margin trading operates investors should abide and practice discipline as well as implement the following measures. But the situation can be quite different during marginal trading, that is why it is necessary to have extra careful actions at such a level, especially for fluctuating markets and diverse risks.

 

FAQ

 

Q1. What to Do if You Invest in a Margin?

• Watch It Tightly: Keep a close watch on your portfolio so you don’t experience a surprise margin call.
• Place Stop-Loss Orders: Use stop-loss orders to limit the odds of losing money on your side.
• Diversification: Spread your investment over several sectors to minimize your risk
• Overleverage: Make a loan only to such extent that you can easily clear it even in unpredictable conditions.
• Track: Monitor interest rates and how brokerage fees impact your profitability as directly as possible.

 

Q2. Should You Invest on Margin?

On margin, buying can multiply the returns but also multiply the risks. Good for an experienced investor, who can closely monitor his portfolio and tolerate the volatility of the market, on margin investing is a do-or-die thing, not for beginners or the risk-averse.

 

Q3. What’s a Margin & How Exactly Does It Work?

A margin is that portion of an investment which a person pays directly from his pocket, and the balance is borrowed from the broker. At all times, the investor must have at least the minimum amount of money required, known as maintenance margin or margin, to keep his account open. If the value falls below that level, then the broker gives a margin call to the client and the investor needs to deposit more or sell his assets.

 

Q4. Why Invest in a Stock on Margin?

This would increase the yield during a bull market. This allows the investor to hold more while having a relatively smaller sum of capital and simultaneously strengthens the potential gain. The same is also applied on short-term opportunities wherein an investor believes that there are going to be high price movements.

 

Q5. What is Margin Investment?

Margin investment is borrowing of money to buy stocks, bonds, or other securities. It gives a leeway to an investor wherein his market level may go up without exhausting all his capital.