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Only for those who can afford to lose it allNov 04 '00 (Updated Nov 07 '00) Write an essay on this topic.Margin investing fully explained with examples Most investors think margin accounts are the best way to "maximize" their investment returns. Although that may be true, they have placed themselves at a higher risk for their return by trading on margin. A margin account is a special brokerage account which allows an investor to purchase securities on credit, by borrowing part of the purchase price from the broker or to sell a securities short (sell a stock that the investor does not own and then buy it back at a lower price and profit the difference). The word margin is the amount of funds that the investor puts up for the securities purchase. Most investors get confused into thinking that margin stands for the "credit" amount when it is the other way. Thus, if the total amount required for a securities purchase is $10,000 and the investor puts up $5,000 margin, the broker's loan will be $5,000. Here is a table of the minimum margin required for securities based on their prices (for Canadian exchanges): (Sorry about the scrunched up way it is shown as epinions doesn't place tabs) Stock Price Minimum margin required Maximum Loan Value -------------------------------------------------------------------------- $5.00 and over 30% of market 70% of market (option eligible securities only) $2.00 and over 50% of market 50% of market $1.75 to $1.99 60% of market 40% of market $1.50 to $1.74 80% of market 20% of market under $1.50 100% of market no loan value -------------------------------------------------------------------------- Here is an example of a margin transaction. Client A buys 1000 shares of ABC company on margin at $1.95 per share. Total cost to buy ABC $1950 minus: broker's maximum loan $ 780 ------------------------------------- equals: margin by client $1170 If ABC falls to $1.60, there is a margin call (requirement for client to put up more money to keep the account up to full margin). Original cost of ABC shares $1950 minus: broker's revised maximum loan (20% of $1.60 x 100) $ 320 ------------------------------------- equals: gross margin required $1630 less: client's original deposit $1170 ------------------------------------- equals: margin deficiency of $ 460 Thus, there is a margin call of $460 to bring the account back up to full margin. If on the other hand, ABC rises to $2.25, there will be excess margin in the account. Original cost of ABC shares $1950 minus: broker's max loan (50% of $2.25 x 1000) $1125 ------------------------------------- equals: gross margin required $ 825 less: client's original deposit $1170 ------------------------------------- equals: excess margin of $ 345 As discussed earlier, securities sold short require to be in a margin account due to the amount of risk involved. Selling a securities short is the process where an investor sells a stock that he/she does not own. What happens is that before placing a sell order, he needs to advice the broker that he is selling short. The broker then "borrows" a stock from another client and sells the security on the market. At some time the investor is expected to "buy back" the stock to cover his position as he originally sold a "borrowed" stock and must return it back to the owner of the borrowed stock. The spread (difference between the price sold and the price bought back) will be the profit of the short seller. This is quite risky as the short seller is betting that the price of the stock will fall so that he can buy it back at a lower price. If the price of the stock instead rises, he will be required to put up more margin to cover his margin call. If the security never falls below the price that the short seller sold it, then, the short seller will lose the amount of money he has put up for margin calls. This is one transaction which can potentially force an investor unlimited losses provided as whatever he puts up on margin call he will never get back. Here is a listing of the margin required for short positions Price of stock minimum credit balance in account -------------------------------------------------------------------------- $5.00 and over (option eligible securities only) 130% of market $2.00 and over 150% of market $1.50 to $1.99 $3.00 per share $0.25 to $1.49 200% of market under $0.25 100% of market plus $0.25 per share -------------------------------------------------------------------------- Here is an example of a short sell transaction on margin Client A short sells 100 shares of ABC for $25 min. account balance required (150% of $2500) $3750 less: proceeds of short sale based on orig price (100 x $25) $2500 ------------------------------------- equals: min. margin required $1250 If ABC falls to $15 and client A covers and takes the profit Total funds in account $3750 less: cost of buying ABC at $15 ($15 x 100) $1500 less: client's orig margin deposit $1250 ------------------------------------- equals: profit on short sale $1000 If ABC rises rather than falls to $30, there would be a margin call and client A would be required to put up more margin. min. account balance required (150% of 100 x $30) $4500 less: proceeds of short sale (100 x $25) $2500 ------------------------------------- equals: margin required $2000 less: original deposit $1250 ------------------------------------- equals: margin call required $ 750 Thus, you can see how profitable margin trading can be, and how risky it can be. You can put up only part of the money required to make a purchase and gain a greater percentage of return due to that, maximizing your money for securities purchase. But, as shown, if the market rises or falls, depending on your transaction, you may lose a lot of money due to the higher level of risk you've taken for the potential return. And, don't forget that while on margin, you must pay interest on the loan from the broker. That is calculated daily until you pay the entire loan back. Although the interest is tax deductible (in Canada) for investment purposes, you still have to pay for it up front before you can deduct it for your yearly income tax. Margin investing is not for the faint of heart. It is certainly not for the beginning investor as the potential for losses are great, especially for short selling where losses are unlimited. But, short selling does not have a time limit, as does option trading (but then that's covered in another review). Most investors that short sell buy the stock back in a relatively short period of time from when they short sold the stock. Most do not have a 6 month horizon. One important thing to note when short selling a stock is to pick one that is quite liquid, well known with regular good volumes. If you short sell a penny stock (strongly not recommended) and the owner of the stock sells it and it is the only stock that your broker holds, guess what. You are forced to buy it back at whatever price the market is at (because you borrowed the stock to sell) and incur losses. Margin accounts can be beneficial for investors who may be short of cash and wish to purchase securities on loan for a short period of time, until they have the cash to pay it back. Otherwise, it may turn out to be more harm than good. Consider the pros and cons of margin investing and determine whether you can benefit or suffer from such an account. Thanks as always for taking the time to read and rate my review.  |
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