What is Buying on Margin?
Buying on Margin is defined as an investor purchases an asset say stock, home or any financial instruments and makes a down payment which is a small portion of asset value and balance amount is financed through a loan from the bank or brokerage firm. The asset purchased will serve as collateral for an unpaid amount.
Buying on Margin Example
- Consider an investor who contacts his broker to buy two December gold future contract. Suppose that the current future price is 1,250 per ounce and per contract size is 100 ounces. The initial margin is 6000 per contract or 12000 in total.
- Suppose now by the end of first-day future price has dropped by$9 from 1,250 to 1,241, as a result, an investor has incurred a loss of 1,800 (200*9) because now 200 ounces of gold which the investor contracted to buy at 1,250 can be sold for only 1,241. The balance of margin account would, therefore, be reduced by 1,800 to 10,200(12000- 1800).
- Similarly, if the price of December gold rose to 1,259 by the end of the first day the balance in the margin account would be increased by 1,800 to $13,800(12000+1800).
Characteristics of Buying an Asset on Margin
- At the end of each trading day, a margin account is adjusted to reflects the investor gain and loss this practice is referred to as daily settlement or marking to market.
- To satisfy the margin requirement an investor usually deposit securities with the broker such as treasury bills for about 95- 100% of face value, stocks for about 50-70% of their face value.
- Margin requirements may depend on the objectives of the trader. A hedger such as a company that produces the commodity on which the futures contract is written is often subject to lower margin requirement than a speculator due to fewer risks of default.
- Day trades and spread transactions often give rise margin requirements. In a day trade, a trader announces to the broker an intent to close out the position on the same day. In spread transaction, the trades simultaneously buy a contract position on an asset for one maturity month and sell a contract on the same asset for another maturity month.
- Margin requirements in a derivative contract such as the future are set up by the exchange. Individuals brokers may require a greater margin from their clients than those specified by the exchange.
- Margin levels are determined by the variability of the price of an underlying asset i.e. higher the variability higher is the margin levels.
Types of Buying on Margin
Let’s discuss the following types.
- #1 – Initial Margin – The amount that must be deposited at the time when the contract is entered into is known as the initial margin.
- #2 – Maintenance Margin – The investor is entitled to withdraw any balance in the margin account in excess of the initial margin. To ensure that sufficient funds are available in a margin account a maintenance margin is set which is lower than the initial margin.
- #3 – Variation Margin – If the investor fails to keep balance in the margin account as a result of which funds fall below maintenance margin the investor receives a margin call and is entitled to bring the margin account equal to the initial margin by the end of the next day. The extra funds deposited is known as variation margin.
- #4 – Clearing Margin – Just as an investor is required to maintain a margin account with the broker, the broker is also required to maintain a margin account with clearing house members and the clearinghouse member is required to maintain a margin account with the clearinghouse which is known as clearing margin.
Advantages
- If two investors agree to trade on an asset for a certain price in the future there are the number of risks involved as one of the investors may decide to back out the deal due to lack of available financial resources to honor the agreement. So here margins play an important role in to avoid defaults on contracts.
- It facilitates daily settlement to avoid adverse movements of asset i.e. when there is a decrease in future price so that the margin account of the investor with the long position is reduced and the investor broker has to pay the exchange which is then passed on to the investor with a short position. Similarly, when the future price increases short position pays money to the in-investor broker of the long position.
- The main advantage of buying an asset on margin is that it helps to magnify return. Let’s say an investor buys 100 shares of stock @$ 20, for a total cost of $2,000 using a 50 percent margin i.e. initial investment required is $1,000 and the balance amount of $1,000 is borrowed from a brokerage firm. Consider the stock increase to $30, as now the stock is worth $ 3000(100* $30) there is the straightaway gain of 50 percent i.e. $1000($3000-$2000).
- However, as the investor has bought the shares on margin, he needs to pay back the amount borrowed which is a margin loan of $1000 by selling the stock at the market price of $30.The whole transaction will fetch a net profit of $1000 after excluding the initial investment made by him. By just investing $ 1000 an investor is able to amplify its gain to 100%.
Disadvantages
- The main disadvantage of buying an asset on a margin that losses can also be magnified. consider the above example, if your stock instead goes down from $20 per share to $10, now the value of an investment is worth $1000 which is equivalent to margin loan of $1000 so the entire investment is lost leaving an investor with zero return.
- An interest charge is also a major concern. An investor needs to pay the interest on the money borrowed from brokerage firm so there is pressure on him to earn more than just to cover interest payment as a result of which he might invest in a risky asset which offers higher return but comes with higher risks too.
Conclusion
Buying on margin involves minimum investment amount to be deposited in a margin account and allows a trader/investor to borrow the balance from a broker and the account is adjusted daily to reflect gains and losses. Margins are an important aspect which allows a trader to trade in various financial products, such as futures, options as well as stocks.
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