Chapter 8 Margin Trading Trading on Margin Leverage is the use of borrowed funds to buy securities Margin is the of investor s equity Margin is collateral for a brokers loan It can be cash or acceptable securities Example Stock bonds mutual funds or derivatives Investors can hold multiple stock in their margin account with a broker and this is their portfolio a group of financial securities A portfolio s value sum of individual holdings Example Value of Stock 1 Value of Stock 2 Value of Stock 3 The value of a stock the of stock X the price of stock Why Trade on Margin It magnifies gains and losses increases the size of your returns Advantage is that it magnifies profits Disadvantage is that it magnifies loses there s interest you have to pay on borrowed money margin loan and there s possible margin calls Rules of Investing in Margin You must have a margin account with a broker To do this you have to have 200 equity or 100 of purchase price whichever is This lets you borrow from a brokerage for investments You can use the money you borrow to buy securities which are kept by the broker least until loans are repaid This lets the brokerage safeguard the money that is lent to you This is where margin calls come in you convert cash securities and the price of the security can vary If the value of your stock goes down you don t have enough equity as collateral and the broker will give you a margin call which generally allows you to add or other securities to bring the value of your margin in your account back up to where you need it to be IF YOU DON T Your broker will sell securities in your account to cover the cost of the loan that you have with them Sometimes they won t give you the curtesy of a Margin Call because it s not requires However it s generally the way it is done Margin is the of investor s equity Minimum margin requirement is set by the Fed and is the least amount of margin that you could have in your account initially Brokers are not allowed to lower this but they can make it higher depends on the securities risk For stock the Fed sets it at 50 and for bonds 30 The less margin you have in your account the less collateral there is for the loan and the riskier the loan is Over the counter stock OTC can t be margined which means there s no collateral value won t let you borrow against them Types of Margin Initial margin is the minimum equity an investor must have in his account the time of purchase Maintenance margin is the minimum equity an investor must have in his account all times Margin call is a notice that equity in an account is below the maintenance margin 3 business days to return to maintenance level OR Account holdings are sold to bring it back up Restricted margin account means that equity is below initial margin required but higher than maintenance margin You can t make any additional margin purchases when this happens Value of an Account initial Equity initial Debt We use initial because the value will change because the price of stock may change So using initial gives us a constant to use The value of an account of shares S X the price P For problems it doesn t matter but just know there is a cost for borrowing 2 things that will always remain constant are 1 of shares purchased 2 The amount of debt borrowed Noteworthy Items 1 Trading on margin has NO impact on the stock price direction the price will change regardless 2 The amount of margin in an account moves in the same direction as the value of the stock portfolio moves 3 The more stock you hold the greater the return gain or loss That is why margin amplifies this because it allows you to buy more stock 4 The smaller the portion of equity the greater the rate of return gain or loss The return is based on the amount of investors personal funds 5 The cost of a margin loan depends on current market interest rates and the loan size Long Purchase Nothing more than a buy a buy of stock with expectations for the price to rise You always want to buy low and sell high Instead of saying I made a long purchase you generally say I bought a share of stock Long position means you purchased a stock that still is in your portfolio You exit a position when you sell a stock and no longer hold it How high can a stock price can rise Potentially infinitely maximum gain There s no limit How much can you potentially lose The price can go to 0 in which case you lose whatever the cost of the stock was maximum loss Short Selling When you short sell you borrow stock and you sell it So first action is to sell stock You can sell stock you don t own by borrowing it from the brokerage house Like banks brokerage houses don t anticipate all owners of their stock to sell at the same time thus they are willing to lend a portion of them out Brokers make with commissions This is different from margin trading because when you borrow money at margin there is a cost but there is not a cost with borrowing stock in short selling Why would you short sell If you thought stock price was immediately going to fall B C if it falls to 0 you make that money and don t have to return stock What happens if a dividend interest is paid while the security is in the shorting process The original owner and the person who buy if from short seller both expect the dividend so you the borrower pay the extra dividend You can only short sell in a margin account so if the stock price increase you have to put more margin and you can possibly lose more than you invested Chapter 9 Investment Information and Securities Transactions Market Averages and Indexes A market average or index is a group of pre selected securities usually chosen for some shared characteristics Practical uses They show us the general market movement For forecasting no guarantee with future events though Benchmarking measuring individual performance of stocks against how the market average index performs the reference point How to use Use the appropriate index which changes base upon what you want to measure reasons why you bought the stock When measuring index you must use the same time period Compare by changes not by amounts Dow Jones Averages Tracks general behavior of component firms just a group of firms that have been chosen to be in this average which were originally put together by the editors or the wall street journal and named after the original 2 publishers Charles Dow and Edward Jones Equally weighted average changes in higher priced components have greater impact …
View Full Document
Unlocking...