What is margin: Meaning and uses

Definition

Margin, in finance, refers to the borrowed funds that an investor uses to purchase securities, such as stocks or bonds.

What is a margin?

A margin allows an investor to increase their buying power and potentially amplify their returns, but it also magnifies the potential losses.

When an investor opens a margin account with a broker, they are essentially borrowing money against the value of their existing investments. The margin is the difference between the total value of securities held in the account and the amount borrowed.

Trading on margin involves paying interest on the borrowed amount, and the securities held in the account serve as collateral. If the value of the investments in the account falls below a certain level, the broker may issue a margin call, requiring the investor to deposit more funds or sell some of the securities to cover the debt.

It’s important to note that trading on margin can be risky and is not suitable for all investors. It’s crucial to have a good understanding of the risks involved and to use margin responsibly.

Example of margin

John wants to purchase 100 shares of Company XYZ, which are currently trading at $50 per share. However, John doesn’t have enough cash to buy the shares outright. Instead, he decides to open a margin account with his broker.

John deposits $2,500 into his margin account. With a margin account, John can borrow additional funds from his broker to purchase the shares. Assuming the broker’s initial margin requirement is 50%, John can borrow up to 50% of the purchase price of the shares, while providing the remaining 50% as his own equity. Therefore, with $2,500 of his own funds, John can borrow an additional $2,500 from the broker.

John uses the $5,000 to purchase 100 shares of Company XYZ at $50 per share. A few weeks later, the price of Company XYZ’s shares increases to $60 per share. John decides to sell his shares and realises a profit.

After selling the shares for $6,000, John repays the $2,500 he borrowed from the broker, plus any interest charges and fees.