What is Buying on Margin?
As a trader you can borrow money to purchase more stock than the cash equivalent.
What does it mean to be buying on margin?
You can easily confuse the meaning and usage of margin. So today I will explain how it works and when to avoid using margin as a new trader.
What is Buying on Margin: Who Lends You Money
Let’s assume you want to buy 100 shares of Apple, currently trading at $175 per share.
Therefore, you need to have $17,500 US dollars in your account.
Or do you?
Because Apple is a high quality stock according to brokers, they typically have a margin rate of 30%.
This 30% is actually the amount of the total purchase you need to put down as cash. The rest, or 70%, is called the loan value of the position.
Therefore, buying on margin 100 shares of Apple will cost you $5,250. This is calculated as $17,500 * 30%.
The rest of the money is lent to you by your broker.
What is Buying on Margin: The Cost of Borrowing Money
Because a broker is lending you money to purchase stocks, they will need to be compensated.
Brokers will charge you a rate of prime plus 1.25% on average. Brokers vary, and you need to double check with yours for the exact figure.
Interest rates are annualized, but paid monthly.
Therefore, the money you are borrowing is $12,250 from a broker.
At an interest rate of 5%, that is $612.50 of interest annually.
Divided by 12, it is a total of roughly $51 USD a month.
As long as the stock you own on margin generates a return of $51 USD or more, it is profitable to buy on margin.
What is Buying on Margin: The Dangers
So if it only costs $51 USD to borrow 70% of the purchase cost, why isn’t everyone rich?
The truth is that margin is what we call leverage.
When the stock market is going up, you pat yourself on the back because you are making money.
But when the stock you borrowed against drops, you will need to meet the new “margin call” to maintain the position.
For example, assume Apple is now down by $10 per share to $165.
The value of your position is $16,500.
Hence, the $1,000 lost is deducted from your $5,250 cash balance.
Now you need to deposit more money in order to maintain the 30% margin requirement.
So while margin might sound like an amazing idea, remember that you need to actively manage your investments.
What is Buying on Margin: Potential Returns Table
Assuming the example from above, you are long 100 shares of Apple at $175 per share.
The table below illustrates your profit and loss as the stock fluctuates.
You will notice that if stocks drop just over 14%, your loss is $2,500 USD.
This means that you will lose 50% of your initial margin capital on just a 14% drop.
Hence, this is why leverage can be very dangerous if it is not managed like a professional trader.
What is Buying on Margin: What to Avoid
One common mistake of new investors is to over borrow and over leveraged as a result.
If you are close to your maximum leverage, a small move against you will wipe out your positions.
When you cannot maintain enough margin, the broker who lent you money liquidates your position.
Why?
Because they want to secure themselves by getting their money back before the losses exceed what you have in cash.
In fact, it is very important that you do not use margin at all when you are first learning.
Buying on margin just amplifies your actions, the good and the bad.
What is Buying on Margin: Conclusion
Margin is just one tool in an investor and traders belt.
When exposing yourself to this risk, always make sure you have an end game. Know when you are gonna close your position before you even get in.
Avoid over leveraging yourself and treat the money like any other loan. Have a plan to pay it back as you make profit in a market rally.
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
