What is Buying Power?
Buying power” is a term used in the trading and investing arena to determine the amount of how much an investor or trader can buy, sell, or invest in a financial market. It refers to the total sum of money available in an investment account, which one will use to execute trades and depends on a couple of different factors, such as balance in the account, margin, and even the type of security being traded.
A concept directly associated with buying power is “excess equity,” which is of prime importance in margin trading. This section will define what constitutes buying power and excess equity, how these work with regards to trading and investing, and present some examples of these in action.
What is the buying power?
Buying power basically refers to the total pool of funds available for the investor or trader to make purchases for securities. This, therefore, is the kind of capital that may be issued on investment purposes based upon the fund available in one’s account, and, as applicable, any margin which is available.
For example, the purchasing power of a margin account is higher than that of cash alone simply because a trader borrows some of the funds from a brokerage firm to execute his/her trades.
In a cash account, it includes the amount of money that is available with the investor. In the margin account, it includes the sum of money that is both available with the investor as well as the sum of money which the broker lends to an investor.
The amount differs depending on the variation in the margin requirement as well as the regulations which the broker imposes.
Trading and Investment Buying Power
It is, therefore what determines buying power and influences either long or short position. Thus if you have your trading account with $10,000 and wish to buy stocks that worth $20,000, then your buying power in the margin account will lend you a sum of $10,000 from the broker, who will therefore double your ability to purchase.
Buying Powers Types
Cash Account Buying Power: The money present can be invested in it reflects the buying power of this type of account. Or in other words, at least there is a clear boundariness for the quantity that amounts to buying power contained inside such accounts via the cash kept. Therefore, buying power remains up to $5,000-worth in equities if cash held accounts balance out to $5,000.
Margin Account Buying Power Buying Power Calculation in a Margin Account The margin account depends on cash balance and amount borrowed from a broker, measured in dollar terms, to determine the buying power. This can make traders have control of much more enormous positions compared to otherwise with just having cash alone.
What is excess equity?
Another important concept with margin accounts is the one known as “excess equity” or “excess margin.” This term describes how much more than the minimum requirement of its equity a margin account possesses to maintain a “maintenance margin.” The minimum is in essence the maintenance level, below, at, or above which one needs to keep the money to hold an open-leveraged position. This happens when a margin account’s equity becomes so low that it is below what it should be and therefore the margin call forces one to add or sell some of his securities up to the minimum margin requirement.
In other words, excess equity is the difference between what is currently in a margin account, known as equity, and the minimum equity required. It actually tells one how much more they are allowed to borrow or to use making additional investments before a margin call would occur.
Effects of Excess Equity to Your Buying Power
The excess equity does directly affect the buying power on the margin account. An investor holding an excess amount of equity on his or her account, that simply means that one only has extra buying power making him or her have tons of potential to buy further securities or increase his position. This is so, since the excess equity can serve like extra collateral that permits any broker to extend certain points of credit toward such investors.
Let’s consider that you have a margin account with $10,000. The maintenance margin on your account is $5,000. Suppose that your assets are appreciated to a value of $15,000. Then you would have $10,000 in excess equity that would leverage your buying power such that you would be able to buy more securities by borrowing.
Examples of Buying Power and Excess Equity in Margin Trading
Let’s take an example to illustrate how buying power and excess equity together enable margin trading.
Example 1: Buying Power in a Margin Account
Assume you have a margin account with a broker whose deposit is $10,000. Then the 2:1 leverage is then offered by the broker such that for each dollar you invest in that account, you are owed for another dollar also. Consequently in the above example, the sum to be employed in investing is $20,000.
Now, as mentioned above about how buying power is measured as:
Account Balance = $10,000
Leverage Ratio = 2:1
Your purchasing power = $10,000 × 2 = $20,000
You now can go in for as much $20,000 worth securities. You put $10,000. And the broker lends you $10,000. Your winnings get magnified in your favor if market goes in your favor. Your losses get magnified so that you lose too much in case, market runs against you.
Example 2: Excess Equity and Buying Power
Let’s discuss what increased equity does to the buying power using a simple example
You have a margin account of $10,000 but this time you make investments in securities which incur you $15,000. Once your investment appreciates its value to $18,000, your equity within that account becomes $18,000 and your requirement of maintenance margin becomes $5,000.
Below is how you calculate excess equity
Current equity = $18,000
Maintenance margin = $5,000
Over- equity = $18,000 – $5,000 = $13,000
This amount of $13,000 over-equity means you have cushion more than required; so you have that extra buying power whereby the more over-equity you have the more is your buying power which offers you the power to take new trades or enhance an existing position through margining which is done according to the entire position.
If you wish to invest these excess equities into additional stocks, your broker will lend you more from which to draw funds for additional purchases. Thus, this means the total purchasing power is strengthened because of the higher equity cushioning in the account.
Risk of power purchasing and surplus equity
Though it may have brought tremendous leverage with increased buying power and excess equity, buying power and excess equity can both enhance the ability to make investments and increase leverage positions. At the same time, it does pose risks. Leverage can both amplify potential returns and losses.
If the market moves against a trader’s position, he will lose huge amounts of money-even to the extent of losing all his or her equity in his or her margin account. Extremely severe conditions in extreme conditions.
Thus, such extreme conditions are bound to reach the critical point calling for a margin call where the investor will have no other way but increase deposit funds or sell some of the assets for it to maintain the needed minimum.
This also exposes the trader to the cost of interest paid from the borrowed funds if it is trading on margin. The interest will add cumulatively to the cost of the investment. When the return in the investment does not exceed the interest cost, it is the likely outcome that the money be lost because, by definition of the system, it cannot go anywhere but down with the market either.
Summary
Buying power can be defined as the total capital, in both cash and loaned from a broker in the case of a margin account, an investor or trader is able to utilize to place transactions in the market. In the case of margin accounts, the leverage ratio enhances the buying power, providing investors with the ability to control larger positions with lesser initial capital. This increases available buying power as investors are allowed to borrow more funds to make additional investments. For example, if the account value of an investor increases, then excess equity provides a cushion to the investor, who can either expand his positions or take up more risk. Whereas buying power and excess equity may enhance potential returns, they also multiply risks. Using leverage can cause dramatic losses if the market declines in an unfavorable way; even at such times, there’s the possibility of a margin call – forcing the investor to increase his or her capital commitment or sell assets. One cannot trade effectively with margin without first understanding buying power and excess equity and how to control for their role in creating risk in both margin and cash accounts.
Conclusion
Another set of concepts that deal with trading and investing are buying power and excess equity. Both dictate precisely how much capital an investor or trader may be able to deploy. Buying power is the amount available to execute trades, and excess equity refers to the amount of equity that is in excess of the necessary margin in a margin account. Excess equity is directly related to the purchasing power since the more the equity, the better collateral for brokers in borrowing and extending credit to them. It further facilitates traders in leveraging their position.
Excess equity and buying power carry a great risk in margin trading. Though they provide enormous opportunities for better returns, they carry a great risk in margin trading. This calls on traders and investors to watchful in handling their position, pay attention to the equity in accounts, and have sufficient preparation for risks when using leverage. With such knowledge, it would be extremely valuable to anyone trading or investing in financial markets because it will ensure decisions taken are well-informed, and risks associated with over-leveraging are minimized.
Frequently Asked Question
1. Buying power in the context of trading
Buying power is just what you can buy in the market using the money you have in your account. If you are using a cash account, then it is just the cash you have. But if you are using a margin account, it is as if you had the cash you have and what your broker would allow you to borrow. Therefore, it works in the following way: you have allowed to invest more money with your cash than you would otherwise spend.
2. How do you compute buying power in a margin account?
Margin trading offers this power of buying through either the cash you have kept in the bank, leveraging facility granted to a trader by his or her broker. For example: You have $5,000 in cash and 2:1 leverage offer; your broker will allow you to exercise control over $10,000. You borrow money from a broker; your transactions therefore are larger.
3. What is excess equity in margin trading?
It is that surplus money which you are holding in your margin account and more than the compulsorily retained amount of money by way of the safety net of your borrowed funds. Thus, excess equity might or might not be just an added cushion so that the possibility of the margin call of your broker reduces the capability of borrowing and/or investment on your behalf.
4. Excess Equity – How it increases your Purchasing Power?
This simply means that you have extra equity that exists beyond the needs of your margin requirements in the account. Therefore, when this happens, then the amount of buying power is augmented because the excess equity gives an impression of additional collateral to your broker. He would let you borrow more money for any new trade, and this is to mean that money can be used to start more new trades.
5. Can my buying power exceed my account balance?
If you use more buying power than what your real account balance is, then you are leveraging. Leverage means borrowing money from the broker to allow you to do bigger trades. That can give you more choices; however, it increases your risk since if the market turns against you, then you might end up owing more than you had actually put into the trade.
6. Can I use excess equity to purchase more securities?
Yes! Excess equity simply represents excess collateral in your margin account. So, if you have an excess cushion of equity, you can use that to up the ante and buy more securities. It is like having more room to make bolder moves without triggering a margin call all at once.
7. What is a margin call and how do I avoid one?
A margin call is reached when the value of one’s investments becomes low in such a way that, in that account, equity is not sufficient to allow for the amount of borrowed money. Put simply, your broker will call in asking you either to place more funds in the account or sell some of the holdings to make up for what is needed. To avoid this, you have to keep an eye on your investments and ensure you have a safety cushion- extra equity-to handle any drops in the market. Then you are less likely to get caught off guard by prices moving against you.
8. What are the risks of using buying power and excess equity?
The biggest risk of this is that although they enable you to trade bigger, they multiply your loss in case the market turns against you. As long as you are borrowing money to invest, you stand the risk of losing more than what you put into the trade. This also means you will pay interest on the borrowed funds and such will add up with time. Therefore, one must be careful in using buying power and always be comfortable with the risks involved.