Our previous post introduced the key principles of trading on margin.
The practice involves taking positions with borrowed money or other assets. It can fatten profits but also result in bigger losses if traders miscalculate direction. In some cases, they might even lose more than all the money in their account. Remember that trading on margin has clear risks and isn’t suited for all investors.
“Margin” is the amount of collateral backing the borrowed cash or securities. Here’s an example of using it to buy stocks:
Say the customer has $10,000 in his or her margin account. Let’s say they also have a 50 percent initial margin requirement. That’s the minimum required by the Federal Reserve, although it can vary by brokerage and situation.
The customer purchases 200 shares of Company X for $100 each, resulting in a total cost of $20,000.
In this case, they essentially borrow $10,000 from the brokerage. Their $10,000 starting deposit is 50 percent of the $20,000 total value, so it meets the initial margin requirement.
Say Company X rallies 50 percent to $150. Their account would now have a value of $30,000. That’s a $10,000 profit — in effect doubling their initial $10,000 deposit. This is how margin, used correctly, can generate leverage: A 50 percent gain in the underlying becomes a 100 percent profit in the client’s account.
But what margin giveth, it can also taketh away! Say Company X is a dud and the stock slides 25 percent to $75. Now the account is down to $15,000 ($75 X 200). The customer still owes $10,000, so their equity got cut in half from the shares losing just one-quarter of their value. Not fun!
On top of that, don’t forget he or she pays interest on the $10,000 they borrowed to buy the stock. Even less fun!
The last important concept is maintenance margin, the amount of positive equity needed to carry an open position. (This number is lower than the initial requirement because otherwise it could get triggered immediately.) The Fed mandates 25 percent maintenance margin for long trades.
Let’s continue with the example of the losing trade above, with the account down to $15,000. Their equity of $5,000 would be 33 percent of the total value, which is still above the limit. Below $13,333, however, we run into trouble. ($3,333 is 25% of $13,333, in case you don’t have a calculator embedded in your cerebral cortex!)
Under that $3,333 level, the brokerage would make a “margin call.” The customer could take a loss and move on, or deposit more cash in order to raise the account’s net equity. Either way, they’re seeing red. Just another reminder that trading on margin involves risk, and isn’t suitable for all investors.
That was long. Next time, we’ll take a look at using margin to sell short!