Margin trading is a form of borrowing that lets you leverage securities. You already own to purchase additional securities protect your account from overdraft or access a convenient line of credit. Margin trading is not designed for any specific type of customer it may be right for any investor looking for additional leverage in their investment.
Here’s an example of how it works? Assume you want to buy 1,000 shares of QRS stock at $10 per share but only have $5,000 in vegetable cash available with a margin account. You can use your $5,000 in cash and borrow the other 5,000 on margin to make your purchase. Without margin with what’s called a cash account. You would need the full ten thousand dollars in cash to make this stock purchase.
Margin Loan Impact Your Investment Return
Assume the QRS stock rises in value from $10,000 to $11,000 and you sell it. You would pay back the $5,000 margin loan and realize a profit of $1,000 that’s a 20% return on your $5,000 investment without a margin loan you would have invested $10,000 in cash and realized only a 10 percent return while leverage is a powerful tool when the price of the security moves in your favor. It is also important to recognize the downside of the stock price false.
Let’s look at the flip side of the same example assume the market value of the QRS stock you purchased with margin for $10,000 falls to $9,000 your equity, which is the value of your position minus the loan balance of $5,000 would fall to $4,000 that’s a 20% loss from a 10 percent decrease in market value. Just like any loan you will also incur interest charges that begin accruing on the date your trade settles. The rate you pay depends on your outstanding margin balance known as the margin debit balance. The rate is typically calculated using a tiered schedule meaning the higher your debit balance the lower the rate.
Margin loans have no set repayment schedule as long as you maintain the required level of equity in your account. Let’s shift focus to this equity requirement along with some other important requirements for margin accounts. In order to buy securities on margin you must also deposit enough cash or eligible securities to meet the initial margin requirement for your purchase. Typically this is fifty percent which is a requirement set by the Federal Reserve Board.
Once you have started buying stock on margin you’re required to maintain a certain level of equity in your margin account. This requirement varies based on the type of security for example a stock generally has a maintenance requirement of twenty five percent and is set by the New York Stock Exchange and FINRA. A Brokerage firm may impose a higher requirement due to factors including. But not limited to holding a significant portion of your account and a single security, which is known as a concentrated position.
The security you are investing in must be eligible for margin in the first place and not all securities are eligible. For Example while most stocks and fixed income securities such as Treasuries are eligible CD’s and money markets are not you can find out whether security is eligible as well as the specific margin requirements for each type of security.
Now we’ll put this information together and see how it all works. Let’s say you have $50,000 in cash and wish to purchase XYZ stock, which has a 50% initial margin requirement. You can purchase up to $100,000 worth of that stock using your margin buying power after the $100,000 stock purchase is made and assuming the stock has a 30% margin requirement. You would have what’s called an initial house surplus more equity. Than is required of $20,000. How surplus is affected at a rate of 70%. So your position could sustain a loss in value of $28571.43 before going into what’s referred to as a margin call a margin.