Margin

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.

Risks of trading on margin

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

• Increased losses: Margin amplifies both gains and losses. If a trade goes against the trader, losses can exceed the initial investment.
• Margin calls: Brokers may issue margin calls if the value of the securities used as collateral falls below a certain threshold. Traders must then deposit additional funds to cover losses or risk having their positions liquidated.
• Interest costs: Borrowing funds for margin trading incurs interest charges, increasing trading costs.
• Market volatility: Fluctuations in asset prices can lead to rapid and substantial losses, especially when trading on borrowed funds.
• Leverage risks: High leverage magnifies both potential profits and losses, increasing the risk of significant financial exposure.
• Regulatory risks: Margin trading is regulated, and changes in regulations can affect margin requirements and trading conditions.
• Liquidity risks: In volatile markets, liquidity can dry up, making it difficult to exit positions at desired prices.

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.