Margin Trading: A Brief Introduction

Margin Trading: A Brief Introduction

Submitted by adil on Wed, 12/28/2011 - 07:12

Margin trading involves buying with the money of brokerage. You can consider it as a loan from your brokerage. Margin trading permits you to purchase a lot more stock than you'd be able to purchase normally. Margin trading can be a high-risk method that will yield an enormous profit if executed properly.

Specifications: To trade on margin, you'll need a margin account. This is different from a frequent cash account, in which you trade applying the money inside the account. By law, your broker is required to get your signature to open a margin account. The margin account may possibly be part of your standard account opening agreement or may possibly be an entirely separate agreement.

Minimum Margin: An initial investment of a minimum of $2,000 is required for a margin account, though some brokerages demand much more. This deposit is identified as the minimum margin.

Initial Margin: It is possible to borrow up to 50% in the purchase value of a stock. This portion is called the initial margin. You can maintain your loan as long as you wish, provided you fulfill your obligations.

Maintenance margin: Maintenance margin would be the minimum account balance you will need to preserve before your broker force you to deposit more funds or sell stock to pay down your loan. When this occurs, it is recognized as a margin call.

Marginable Securities Status: Marginable securities within the account are collateral. You'll also need to pay the interest on your loan. The interest charges are applied to your account unless you choose to produce payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on. Consequently, Purchasing on margin is primarily applied for short-term investments. The longer you hold an investment, the greater the return which is necessary to break even. In case you hold an investment on margin for a long time frame, the odds that you will make a profit are stacked against you.

Stock Buying Restrictions: Not all stocks qualify to be bought on margin. The Federal Reserve Board regulates which stocks are marginable. As a rule of thumb, brokers won't permit buyers to buy penny stocks, over-the-counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) on margin because of the day-to-day risks involved with these kinds of stocks. Individual brokerages may also choose not to margin particular stocks, so check with them to see what restrictions exist on your margin account.

Margin Call: If the equity (value of securities minus what you owe the brokerage) inside your account falls below the maintenance margin, the brokerage will issue a "margin call". A margin call forces the investor to either liquidate his position inside the stock or add more money towards the account.

Example: Let's say you buy $20,000 worth of securities by borrowing $10,000 from your brokerage and paying rest by yourself. If the industry value from the securities drops to $15,000, the equity within your account falls to $5,000 ($15,000 - $10,000 = $5,000). Given that maintenance requirement is 25%, you must have $3,750 in equity within your account (25% of $15,000 = $3,750). Therefore, you are safe in this situation as the $5,000 worth of equity inside your account is greater than the maintenance margin of $3,750. Now suppose marketplace value of the securities falls to $12,000. The equity inside your account falls to $12,000 - $10,000=$2,000. The maintenance requirement is 25%. It's essential to have a value equal or higher than 25% of $12,000, which is $3000. But in this case you have got a value $2,000. Consequently, the brokerage might issue you a margin call.

The Worst Case: If for any cause you don't meet a margin call, the brokerage has the right to sell your securities to enhance your account equity till you are above the maintenance margin. Even scarier could be the reality that your broker could not be required to consult you prior to selling! Under most margin agreements, a firm can sell your securities without waiting for you to meet the margin call. You can't even control which stock is sold to cover the margin call.

It is important to read your brokerage's margin agreement extremely carefully just before investing. This agreement explains the terms and conditions of the margin account, such as: how interest is calculated, your responsibilities for repaying the loan and how the securities you acquire serve as collateral for the loan. I hope this article has cleared all your initial concerns about margin trading. Be a part of IntelliTraders for complete online trading guidance.