Buying on Margin
Buying on margin means borrowing money from a broker to buy or invest in financial securities. It’s similar to taking a loan from your broker (through a margin account). It is also called Margin trading. It is a risky approach which when implemented correctly, can generate a huge profit. Margin Trading helps you to acquire more shares than you otherwise could. When you buy on margin, the stocks you purchase are kept as collateral until you pay off the loan.
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How does Margin Trading work?
You need a margin account to trade on the margin. However, this differs from a regular cash account, where you use the money in the account to trade. They serve as leverage and can therefore magnify earnings. This margin account could be the standard agreement to open your account or maybe a different agreement. Unless you meet your commitments, you can keep your loan as long as you want. When you sell the stock in the margin account, the proceeds will be credited to your broker initially against the repayment of the loan before it is fully paid out. There is also a limit known as Maintenance Margin. This amount is based mainly on the creditworthiness of the borrower. It is the minimum balance you have to maintain before your broker obliges you to pay off your loan or deposit further funds. This is called Margin Call.
Example of Buying on Margin:
Suppose you want to buy company ABC’s stock which is currently trading at $500. When you buy it on margin, the broker will give you a margin requirement or the amount that you need to contribute. If that contribution is 70% then you need to put 70% of the price yourself and the broker will put up the remainder. So at $500, you will have to pay $350 for the stock and the remaining $150 will be paid by the broker. Now if ABC’s stock rises to $600, the broker can sell the stock for $600 and redeem the loan of $150 and give the remainder $450 back to you. Hence, you make a profit of $100 since you put in only $350.
Benefits of Buying on Margin:
- Increases the purchasing power of investors.
- Access to capital helps investors leverage their position in the market through security or cash.
- Profile diversification.
- If your debt hasn’t exceeded your maintenance margin, you can pay back the loan on a flexible schedule.
- High profits on successful trades.
Risks of buying on margin:
- There is a risk of losing more funds than you deposited.
- Inability to meet maintenance margin resulting in a margin call.
- The broker can sell the securities in your margin account if the equity falls below the maintenance margin.
- Heavy losses on unsuccessful trades.
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Margin Trading is not for everybody. Based on the price fluctuations of the marginable securities in the portfolio, the purchasing power of the margin account changes regularly. It is a double-edged sword. It can magnify your profits as well as losses. Buying on Margin can be extremely risky. It should be done according to the investor’s risk appetite with caution. Margin Trading and short selling can be used to profit off of falling markets.
Author – Abha Shetty
About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.