buying on margin example
Buying on Margin Example: How to Profit from Leverage
Buying on margin is a strategy that allows investors to borrow money from a broker to purchase more securities than they could otherwise afford. By using leverage, investors can amplify their returns when the price of the securities rises. However, buying on margin also involves more risk, as the investor may lose more than their initial investment if the price of the securities falls.
In this article, we will explain what buying on margin means, how it works, and what are some of the advantages and disadvantages of this strategy. We will also provide a buying on margin example to illustrate how an investor can profit or lose from using leverage.
What is Buying on Margin?
Buying on margin is a form of borrowing that allows investors to use their existing securities as collateral to buy more securities. The broker lends the investor a portion of the purchase price, usually up to 50% of the value of the securities. The investor pays interest on the borrowed amount until they repay the loan.
The securities that the investor buys with the borrowed money are held in a margin account, which is separate from a regular cash account. The broker has the right to sell the securities in the margin account if the value of the securities falls below a certain level, known as the maintenance margin. This is to protect the broker from losing money if the investor defaults on the loan.
The maintenance margin is usually set at 25% of the total value of the securities in the margin account. This means that if the value of the securities drops by more than 25%, the broker will issue a margin call, which is a demand for the investor to deposit more cash or securities into the margin account to bring it back to the required level. If the investor fails to meet the margin call, the broker can sell some or all of the securities in the margin account without notifying the investor.
How Does Buying on Margin Work?
To understand how buying on margin works, let’s look at an example. Suppose an investor has $10,000 in cash and wants to buy 100 shares of XYZ stock, which is trading at $100 per share. The investor can use their cash to buy 100 shares outright, or they can use margin to buy more shares.
If they use margin, they can borrow up to 50% of the purchase price from their broker. This means they can buy up to 200 shares of XYZ stock with $10,000 in cash and $10,000 in borrowed money. The investor will pay interest on the borrowed amount until they sell the shares or repay the loan.
The investor’s margin account will have a value of $20,000 (200 shares x $100 per share), and a debt of $10,000 (the borrowed amount). The equity in the margin account is $10,000 (the value minus the debt), which is equal to 50% of the value (the initial margin). The maintenance margin is 25% of the value, which is $5,000 in this case.
What are the Advantages and Disadvantages of Buying on Margin?
Buying on margin has some advantages and disadvantages that investors should be aware of before using this strategy. Here are some of them:
- Buying on margin can increase an investor’s returns when the price of the securities rises. For example, if XYZ stock goes up by 10% to $110 per share, the investor’s profit will be $2,000 (200 shares x $10 per share) if they use margin, compared to $1,000 (100 shares x $10 per share) if they use cash only. This means that buying on margin can magnify an investor’s gains by using leverage.
- Buying on margin can allow an investor to diversify their portfolio by buying more securities with less cash. This can reduce their exposure to specific risks and increase their potential returns.
- Buying on margin can enable an investor to take advantage of market opportunities that may arise when they do not have enough cash available. For example, if an investor expects a stock to rise in value soon, they can use margin to buy more shares quickly without having to sell other securities or wait for funds to clear.
- Buying on margin can increase an investor’s