The demand for robust returns in the capital markets environment has created an environment where investors require capital to enhance their returns. This demand has generated a sophisticated process in which investors can borrow capital that is used to invest in stocks and futures to enhance their returns. Investing with margin is a way that investors can find a great rate of return.
Most brokers offer investing with margin as a product which allows investors to borrow capital using the securities they hold within their account as collateral. Margin provides leverage, which can enhance and detract from returns.
What Is Investing With Margin
Margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counter party. Investing with margin is most often associated with a broker or an exchange. The collateral that can be used to post margin can be in the form of cash or securities, and it is deposited in a margin account.
The initial margin is a guarantee and offsets losses should they occurs. Margin is calculated by using the historical volatility of a financial security and calculating the potential losses that could occur on a given day. The margin system is a mechanism that insures there is sufficient cash to cover losses and protects a broker from risks of losses.
Margin trading and investing with margin creates leverage or gearing for an investor which can enhance or detract from the returns of a portfolio. For example, if an investor purchases $50 dollars’ worth of currency and it increases to $60 dollars the investor makes 20 percent on their trade.
If on the other hand, the investor uses margin to purchase the stock and only uses $25 dollars to purchase a $50 dollar of currency, then a $10 dollar increase (from $50 to $60) would generate a return of 40 percent ($10 divided by $25). With a margin account the investor would need to pay an interest rate on the borrowed capital which detracts from the returns.
Leverage works both ways which means that traders need to be cognizant of their borrowing. If you trade $100 dollar but only put up $10 and you lose 10% on your trade, you will wipe out your entire capital. Brokers are aware of these risks and therefore they are constantly calculating the margin you need to hold in your account to make sure they are solvent.
Understanding that you are at risk of losing your entire portfolio, a broker would likely place a margin call at a level that will ensure that you will have enough in your account should the position move against you when you are investing with margin. Once you lose for example 5%, the broker might issue a margin call, asking you to post another $5 in your account.
If you fail to meet the margin call, your broker will liquidate your trades to make sure they are not on the hook for your losses. Brokers usually make you sign an agreement that they have the right to liquidate your account if a margin call is issued and you do not respond in a timely manner.