Margin Trading: What is Margin?
Margin is a term used in finance to refer to the collateral that an investor must deposit with their broker or exchange to offset the broker's or exchange's credit risk. Credit risk is created when an investor borrows funds from a broker to purchase financial instruments, borrows financial instruments to sell them short, or enters into a derivatives transaction.
When an investor purchases an asset on margin, he/she borrows the remaining balance from a broker. Purchasing an asset on margin refers to the first payment made to the broker; the investor utilizes the marginal assets in their brokerage account as collateral.
In general business, the margin is the difference between the selling price of a product or service and the cost of production, or the profit-to-revenue ratio. Margin may also refer to the part of an adjustable-rate mortgage (ARM) interest rate that is added to the adjustment-index rate.
Margin is a term that refers to the amount of equity in an investor's brokerage account. To margin" or "buy on margin" means to acquire shares using money borrowed from a broker. To do so, you must have a margin account, not a basic brokerage account. A margin account is a type of brokerage account in which the broker loans the investor money to enable them to purchase more securities than they could with their account balance alone.
Margin trading is practically the same thing as using the cash or securities already in your account as collateral for a loan. The collateralized loan carries a fixed interest rate that must be paid regularly. Because the investor is utilizing borrowed funds, or leverage, both his losses and profit will be increased. Margin investing can be advantageous in situations when the investor expects to earn a larger rate of return on the investment than he pays in interest on the loan.
For instance, if your margin account requires a 60% initial margin requirement and you wish to acquire $10,000 worth of assets, your margin would be $6,000, with the remainder borrowed from the broker.
Margin Trading: What is Leverage?
Leverage is defined as the ratio of the amount of the margin to the amount of borrowed money used to fund it: 1:100, 1:200, or 1:500. Leverage of 1:100 implies that the trader's trading account must have an amount 100 times smaller than the transaction total.
Leverage is a term that refers to the loan ratio. Its value might range greatly between 1:1 and 1:500. This indicates that a consumer can purchase or sell currencies in amounts exceeding the margin by a factor of 500! For instance, if a trader selects the 1:100 leverage and deposits $100, he or she may acquire the currency for 100*100=$10,000. A trader conducts a sell after purchasing a currency with a positive rate change, so profiting from currency rate swings. In other words, the deal is completed by a trader. When a transaction is closed, the credit is automatically closed; nevertheless, the margin and profit gained by the trader remain on the trader's account. This strategy enables traders to earn huge gains, even exceeding the margin required for a particular transaction, even when foreign currency rates fluctuate slightly. The trader's risk is restricted solely by the margin amount, as the dealing center does not give the actual value of the opened transaction, but only promises the crediting of the loss or profit in full at the deal's conclusion. Closing a transaction is the inverse operation: when purchasing a certain quantity of currency, the same amount is sold, and vice versa.
Positions with Leverage
Margin transactions occur when investors borrow a portion of the purchase price of a stock from their brokers and then deposit the acquired shares with the brokerage company as collateral for the loan. The broker normally charges a margin credit rate that is 1.5 percent more than the rate paid by the bank originating the loan. The bank rate (also known as the call money rate) is typically roughly 1% lower than the prime rate. The difference between the market value of the collateral stock and the amount borrowed is referred to as the investor's equity.
Investors can increase their upside potential, but they also increase their downside risk. Leverage is equivalent to 1/margin percentage.
Purchasing stocks on margin raises the financial risk associated with the investment, necessitating a greater rate of return.
• Percentage margin: The ratio of an account's net worth, or "equity value," to the market value of its holdings.
• Maintenance margin: The needed ratio of equity to the stock's entire value. It safeguards the broker in the event of a stock price decrease.
• Margin call: If the percentage margin falls below the required maintenance margin, the broker makes a margin call, asking the investor to fund the margin account with additional cash or securities. If the investor does not make timely payments, the broker will sell the collateral shares to repay the loan.
Assume an investor pays $6,000 toward the purchase of $10,000 worth of stock ($100 shares at $100 per), with the remainder borrowed from the broker. The maintenance margin is 30%. 60 percent is the initial percentage margin. If the stock price falls to $57.14, his stock will be worth $5,714. Given the loan amount of $4,000, the percentage margin is now (5,714 - 4,000) / 5714 = 29.9%. A margin call will be sent to the investor.
When investors purchase stocks or other assets on margin, they increase the financial risk associated with the investment above and above the intrinsic risk of the security. They should therefore enhance their needed rate of return.
Return on Margin Transaction
Calculating the rate of return on a margin transaction is identical to calculating the rate of return on an unleveled transaction; the only difference is that the margin interest paid must be calculated and subtracted. The rate of return should be calculated based on the initial equity investment, not on the total cost of the assets purchased. Commissions and other upfront costs should be factored into the initial equity amount.
Example of a Margin Transaction
A trader purchases $100,000 worth of a highly volatile stock at a leverage ratio of 2.5, receives an $800 special dividend after six months and sells the stock for $200,000. At the time of purchase, the commission is $10. The trader is charged an interest rate of 8% on the money borrowed.
To calculate the rate of return, we simply divide the profit (or loss) by the initial equity investment.
Let us begin by calculating the amount of money borrowed by the trader to complete this transaction.
Divide the full $100,000 purchase price by the leverage ratio of 2.5 to determine the equity investment.
Equity investment = $100,000 / 2.5 = $40,000
And the remaining must be borrowed:
Borrowed amount = $100,000 – $40,000 = $60,000
The amount of interest that the trader must pay over a year is equal to the interest rate on the loan multiplied by the loan amount:
Interest paid = $60,000 × 8% = $4,800
Now, let's look at the profit calculation:
To determine the total initial equity investment, simply multiply the $40,000 calculated above by the $10 commission on purchase:
- Sale Price $200,000
- Purchase Price $100,000
- Realized Gain (Loss) $100,000
- Purchase commission $10
- Dividend $800
- Margin interest $4,800
- Sale commission $10
- Return $95,980
Equity investment plus commission = $40,000 + $10=$40,010
Finally, the rate of return on this deal may be calculated as follows:
Rate of return = $95,980 $ 40,010 = 239.89%
Margin Trading: Margin Calls
Margin call refers to the broker's need that the customer deposits more funds or securities to cover the cost of a short sale or "buy with leverage" transaction that was facilitated by the broker's credit and resulted in current losses. Generally, in such instances, the customer is asked to submit extra collateral within one day and is held liable for the broker's possible losses.
Margin Calls: An Overview
Buying on margin refers to an investor who pays for securities purchases and sales with a mixture of their capital and money borrowed from a broker. Equity in investment is equal to the market value of the securities less the amount borrowed from the broker.
A margin call occurs when an investor's equity, expressed as a percentage of the total market value of assets, falls below a certain level (called the maintenance margin). If the investor is unable to pay the requisite amount to bring the value of their portfolio up to the account's maintenance margin, the broker may be obliged to sell the account's securities at market value.
Both the New York Stock Exchange (NYSE) and the Financial Industry Regulatory Authority (FINRA), which regulates the majority of securities companies in the United States, require investors to maintain a margin of at least 25 percent of the entire value of their assets.
Certain brokerage firms charge a higher maintenance fee—up to 30 percent to 40 percent.
The statistics and prices associated with margin calls vary according to the percentage of margin maintained and the stocks concerned.
In some cases, an investor can determine the precise price at which stock must fall to trigger a margin call. Essentially, it occurs when the account value, or account equity, equals the required maintenance margin (MMR). The formula would be as follows:
(Margin Loan) / (1 – MMR) = Account Value
For instance, consider an individual who establishes a margin account with $5,000 of their own money and $5,000 borrowed as a margin loan from their brokerage business. They make a margin buy of 200 shares of a stock at $50. (Under Regulation T, which establishes the maximum amount of credit that brokerage firms and dealers may give to consumers for the purchase of stocks, an investor may borrow up to 50% of the purchase price.) Assume that this investor's broker requires a 30% maintenance margin.
The investor's account currently contains $10,000 worth of shares. A margin call is triggered in this scenario when the account value falls below $7,142.86 (i.e. $5,000 / (1 – 0.30), which amounts to a stock price of $35.71 per share.
Assume, for the sake of argument, that the price of this investor's shares decreases from $50 to $35. Their account is now worth $7,000, triggering a $142.86 margin call.
In this case, the investor has three options for resolving their $142.86 margin deficiency:
1. Fund the margin account with $142.86 in cash.
2. Reinvest $142.86 in marginal securities in their margin account, restoring their account value to $7,142.86.
3. Sell stock for $333.33 and use the profits to pay off the margin debt; at the current market price of $35, this equates to 9.52 shares, rounded up to ten.
Margin Trading: Conclusion
If a margin call is not satisfied, the broker may terminate all active trades to restore the account to its minimal value. They may be permitted to do so without seeking clearance from the investor. This practically indicates that the broker has the authority to sell the investor's stock holdings in the required quantities without notifying the investor. Additionally, the broker may impose a commission on certain transactions. This investor is held liable for any losses incurred throughout the course of this transaction.
Margin trading provides banks with a unique chance to earn a high rate of interest on short-term capital. Small investors, too, have access to bank funds without being abused by stockbrokers and other financial professionals. Margin trading is the most transparent form of leveraged asset acquisition. It acts as a conduit for cash to be channeled into the stock markets. Margin trading also reduces the likelihood of being scammed.
Banks will need to have proper risk management procedures to protect the loans they make secured by securities. Additionally, payment system reforms are required to strengthen the infrastructure for payment transmission. Margin trading is an alluring mechanism that assures a no-default market through high levels of collateral and provides investors with modest leverage, hence improving the stock market's liquidity.
For further details and information on margin trading transactions, please visit our website InstaForex.