Margin trading, simply defined, is the ease of borrowing a certain amount from a brokerage firm, add in your cash on hand, and start buying stocks. Don’t take it as that simple, however, because in reality there are different factors to consider before one could start with this trading strategy. It is important to know the advantages, especially the disadvantages of this strategy, since it is dubbed as a very risky one.
First, let’s define some terms. “Margin” in general refers to the edge or border of something or the amount by which an item falls short or surpasses another item, while “to margin” means to use borrowed money to purchase securities.
Before one can start to trade on margin, one needs a margin account. This is different from a regular cash account, where one trades using the money in the account. By law, the broker is required to obtain the owner’s signature to open a margin account, and then an initial investment is needed. At least $2,000 is required, though some brokerages require more, and is called as the “minimum margin.” Once your account is opened and operational, the trader can borrow up to 50% of the purchase price of a stock, or less like 10% or 25%. The remaining 50%, 90%, or 75% depending on your margin is to be paid in cash by the trader and is called “initial margin.” According to Regulation T of the Federal Reserve Board, the standard initial margin is 50%, but this is only a minimum and some brokerages require traders to deposit more than 50%.
Mr. Cruz deposited $10,000 in his margin account. This initial margin is 50% of the purchase price, which means the broker would need to supplement the other 50%. He now has $20,000 worth of “buying power.” If he bought $5,000 worth of stocks, he still has $15,000 in buying power left. Mr. Cruz has enough cash to cover this transaction, so he hasn’t used any of his loans. He only starts borrowing the money when he buys securities worth more than his initial margin of $10,000.
To maintain his margin account, Mr. Cruz needs a “maintenance margin.” It is needed as a minimum account balance traders like him must maintain before the broker will for them to deposit more funds or sell stock to pay down the loan. Since the market is volatile, if the equity (value of securities minus what he owes the brokerage) in Mr. Cruz’s account fell below the maintenance margin, the brokerage will issue a “margin call.” This call forces Mr. Cruz to either liquidate his position in the stock or add more cash to his account.
Continuing with the previous example, if the market value of the securities dropped to $15,000, the equity in Mr. Cruz’s account would be $5,000 ($15,000 - $10,000 = $5,000). Assuming his maintenance margin is 25%, he must have $3,750 in equity in his account. Thus, he is fine. However, if the maintenance requirement is 40%, he has less equity left in his account. The brokerage may issue a margin call here.
Disregarding equities and margin calls, what if at the opening of his account Mr. Cruz bought 200 shares worth $100 each from Apple? He has used up all his account, twice more than he would have with just his cash. And then Apple released a new iPhone and the price of shares rose to 25% at $125. He decided to cash out and his investment is now worth $25,000. He pays back the brokerage’s $10,000 and keeps the remaining $15,000. From his initial $10,000, he has now earned 50% more. (That’s disregarding commissions and interests, which should be deducted from the profit)
· The loan can be kept as long as the trader wants, as long as obligations are met.
· Margin is about leverage. It amplifies every point that a stock goes up. If the trader picked the right investment, margin can dramatically increase their profit.
· A 50% initial margin allows traders to buy up to twice as much stock as they could with just their cash.
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