Margin stock

Table of Contents

Margin stock
What is margin stock?
Understanding margin stock
Calculation of margin stock
Workings of a margin account
Example of a margin stock
Frequently Asked Questions

Margin stock

Margin trading enables traders and investors to use leverage to boost their profits on their assets. A specific set of guidelines, including minimum initial margin demands and keeping up margin levels, are specified by the brokerage company for margin trading.

Margin stocks can be a high-risk strategy and require careful consideration and monitoring.

Before using margin to trade, it is crucial for investors to thoroughly comprehend these regulations since failing to comply with them might result in the forced selling of stocks to cover the margin call. Margin stocks often come with a higher level of risk but also the potential for more significant gains.

What is margin stock?

Margin stock refers to borrowing funds from a brokerage firm to purchase securities. Investors can borrow capital from their brokerage to buy securities when they invest in margin stocks. As this funding takes place on margin, only a tiny portion of the investor’s investment is considered a security. The broker provides the remaining funds. This enables investors to increase the return on their assets by using leverage. But it also puts them at greater risk.

Understanding margin stock

In general, understanding the meaning of margin is crucial for understanding margin stocks. When an investor borrows money from their broker for investing, this is referred to as a margin deposit. The margin requirement is often indicated as a proportion of the overall investment. For example, if the required margin is 50%, the investor would have to put up half of the whole investment value as collateral. The broker lends the remaining 50%.

Investing in margin stocks can be a double-edged sword. On one side, it allows investors to leverage their assets to increase their profits. On the contrary, if the stock price falls, the losses may also increase. In reality, the investor can be vulnerable to a margin call if the stock price drops below a predetermined threshold known as the maintenance margin. He would thus need to add more money to his account to achieve the maintenance margin requirement. Otherwise, he would run the danger of the broker liquidating his holdings.

Calculation of margin stock

To calculate the margin required for a stocks purchase, you need to follow the following steps:

Firstly determine the initial margin requirement set by your broker. This is usually a percentage of the total value of the securities being purchased.
Multiply this percentage by the total value of the stocks to calculate the initial margin amount.

Subtract the initial margin amount from the total value of the stocks to find the loan value.
Divide the loan value by the initial margin amount and multiply by 100 to calculate the margin percentage.

Workings of a margin account

A margin account is required to trade on margin. This differs from a typical cash account, where trading is done using the funds in the account. When you open a margin account, you deposit money that will be used as security for a loan to buy stocks or securities. With this, you may obtain a loan for up to 50% of the investment’s acquisition price. Therefore, if you invest US$15,000, you can purchase up to US$20,000 worth of stocks.

Margin trading is governed by the Securities and Exchange Commission, or SEC, and the Financial Industry Regulatory Authority, or FINRA, which have strict guidelines about how much you must deposit, how much you may borrow, and how much you must maintain in your account at certain times.

Example of a margin stock

One real-world example of margin stocks is when an investor borrows money from the broker to purchase shares of a particular company. The investor can trade the shares at a gain if the stock increases in value, pay back the loan, and retain the profit as return. However, if the stock price drops, the investor could have to liquidate the shares at a loss to repay the loan.

Imagine X made a US$10,000 deposit to his margin account. This implies that he has an equivalent purchasing power of US$20,000 due to his 50% down payment. In that case, he remains with US$15,000 of purchasing power if he buys US$5,000 worth of shares.

So, he has the necessary cash to complete this purchase and hasn’t used any of his margins. He begins borrowing money only when his purchase shares are valued at more than US$10,000.

Frequently Asked Questions

What is a margin account?

A “margin account” is a particular kind of brokerage account where the broker-dealer loans the investor money to buy securities while employing the account as collateral. While margin gives investors more purchasing power, it also exposes them to the possibility of losses.

What are the advantages of margin stock?

The main benefit of using margin is the potential to leverage your assets to boost earnings when the value of your holdings shifts in your favour. Additionally, If you have a concentrated stock position in your account, margin purchasing allows you to diversify your portfolio by utilizing the margin buying power.

What are the limitations of margin stock?

One major limitation of margin stock is the risk involved. Margin trading amplifies gains and losses, so if the price of the stock purchased on margin declines, the investor may be forced to sell at a loss to repay the borrowed funds.

Additionally, margin accounts require investors to maintain a minimum level of equity, known as the maintenance margin. Failure to meet this condition can result in a margin call and potentially lead to the forced liquidation of securities in the account. Therefore, it is essential for investors to cautiously analyse their financial situation and risk tolerance before engaging in margin trading.

How does buying on margin work?

Buying on margin increases investors’ buying power and potentially generates higher returns. The process involves the investor putting up a percentage of the total purchase price, known as the initial margin, while the remaining amount is borrowed from the broker.

The investor then holds the stocks as collateral for the loan. It is important to note that buying on margin involves risk, as any decline in the value of the stocks can result in a margin call, requiring the investor to either deposit more funds or sell some of the securities to cover the losses. Overall, buying on margin can be helpful for experienced investors, but it requires careful consideration and understanding of the risks involved.

Why is buying on margin risky?

The primary risk of purchasing on margin is that you might lose many more funds than you initially put in. A decrease of at least 50% in equities partially financed with borrowed money results in a loss of at least 100% in your portfolio, including interest and fees.