Stocks:
Advantages and Disadvantages of Margin
Why use margin? In a word, leverage. Just as companies borrow money to
invest in projects, investors can borrow money and leverage the cash they
invest. If you pick the
right investment, margin can dramatically increase your profit.
A 50% initial margin allows you to buy up to twice as much stock as cash in your
account. It's not difficult to see how there is the possibility to make
significantly more money in a margin account than you can by trading with a cash
account. It simply depends on whether your stock rises or not. Also, interest on
margin loans at most brokerage accounts are lower than credit cards and auto
loans. If you ever need money and you are not ready to sell your stocks, you can
take out a margin loan without a credit check.
The best way to demonstrate the power of leverage is with an
example. Lets say you bought $20,000 worth of securities using $10,000
of margin and $10,000 of cash. You bought it at $100 and you
feel that it will rise dramatically. Normally, you'd only be able to buy 100
shares (100 x $100 = $10,000) with cash account. Since you're investing on margin you have the
ability to buy 200 shares (200 x $100 = $20,000).
The next month, share price went up 20% and you sell it at $120 giving you $24,000
total (200 x $120). After paying back your broker the $10,000 you originally borrowed,
you'll net $14,000, of which $4,000 is profit . That's a 40% return when the stock
went up 20%. To simplify this transaction, we didn't take into
account commissions and interest. Otherwise, these costs would be deducted from
you profit.
Of course leverage can go both ways, if we take the same
scenario but instead of stock going up if the price of the stock went down 20%
to $80. You would have a loss of 40% instead of 20%.
What is a Margin Call?
Buying on margin can be potentially profitable but also potentially risky. To
protect themselves, brokers issue a margin call if your margin account falls
below the required maintenance level or a specific percentage of its original
value. The New York Stock Exchange (NYSE) and the National Association of
Securities Dealers (NASD) set that requirement at 25%, and some brokerage have
stricter limits. You could get a margin call, for example, if the market price
of the stock you bought on margin drops significantly. If you get a margin call,
you must deposit additional money to meet the call, bringing the balance of the
account back up to the margin required. Otherwise, your stock may be sold at a
loss, and your broker repaid in full.
For example, Let's say you purchase $20,000 worth of securities by
borrowing $10,000 from your brokerage and paying $10,000 yourself. If the market
value of the securities drops to $15,000, the equity in your account falls to
$5,000 ($15,000 - $10,000 = $5,000). Assuming a maintenance requirement of 30%,
you must have $4,500 in equity in your account (30% of $15,000 = $4,500). Thus,
you're fine in this situation as the $5,000 worth of equity in your account is
greater than the maintenance margin of $4,500. But, assume the maintenance
requirement of your brokerage is 40% instead of 30%. In this case, your equity
of $5,000 is less than the maintenance margin of $6000 (40% of $15,000 =
$6,000). As a result, the brokerage may issue you a margin call.
If you do not meet a margin call for any reason, the brokerage has the right to
sell your securities to increase your account equity until you are above the
maintenance margin. Even scarier is the fact that your broker may not be
required to consult you before 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. Because of this, it
is imperative that you read your brokerage's margin agreement very carefully
before investing. The agreement explains the terms and conditions of the margin
account including how interest is calculated, your responsibilities for repaying
the loan, and how the securities you purchase serve as collateral for the loan.
Next==>>
What is short
selling?
We live by the Golden Rule.
Those who have the gold make the rules.
-- Buzzie
Bavasi --
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