Sunday, December 9, 2012

How the Margin account work?

Margin account is one of the way for those qualify to borrow money against your existing stocks to buy more stocks. Different broker will establishes different margin of maintenance requirement.

For example, if you deposit $20,000, you would have $50,000 of buying power. (some broker give 2.8x, which make the buying power as $56,000) You can margin up to 60% of your stock price (some time 65%), in other words, you use $20,000 of your own money and broker will loan you $30,000. If 65% of margin, then the high side you can borrow is $33,000. Some stock may have lower limit (cap price less than 1), hence the securities value will become less. Let assume we buy 10,000 shares of a stock at $5 per share and below are some of the possible scenarios.

Scenario 1: Cap price 1 and stock price flag
The 10,000 shares still worth $50,000 (securities value). In this case, there's no margin call as margin is 60% (money borrow $30k divide by securities value $50k), however, you lose out, as you need to pay for the interest of $30k.

Scenario 2: If cap price 0.90 and stock price flag
In this case, the securities value worth $45,000 only although the actual market value is $50,000. When the broker calculate the margin, it would become 66% (money borrow $30k divide by securities value $45k). This leave no room for the investor as once the stock price goes below $5, margin call will follow.

Scenario 3: Cap price 1 and stock price goes south to $4
The 10,000 shares now worth $40,000 (securities value). In this case, when the broker calculate the margin, it would become 75%. Margin call will follow and investor will need to top up $6153 to reduce the margin to 60% or the broker will force sell some stock to make the margin become 60%.

Scenario 4: Cap price 1 and stock price goes up to $6
The 10,000 shares now worth $60,000 (securities value). Investor can withdraw $9,000 or buy additional stocks with this value. Another option, sell the stock at $60,000 and return the broker $30,000, a nice return base on initial deposit of $20,000.

Below are some of the important lesson one need to learn from margin account:

  • margin amplifies a portfolio's performance, make losses and gains greater than they would have been.
  • All securities in account are held as collateral for margin loan
  • If you fail to meet the margin call, the broker may sell off some or all your investment to cover the margin requirement
  • It is possible to lose more than you invest when using margin.
  • Use margin account to buy stable blue chip stocks with cap price equal to 1 is better than cap price below 1.
  • Interest rate charged by broker, terms and conditions may subject to change

Some people say, margin account is a two-edged sword. It's a great deal if the stock goes up, but a disaster if the stocks goes down. It's definitely not suitable for beginners as it involve market risk and need to follow strictly on tight money management.

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