FIN 3244 Chapter 8 Notes Markets and Transactions Trading on Margin Leverage the use of borrowed funds to buy securities Margin the of an investor s equity Example An investor makes a 1 000 investment of which 750 is his and the remaining 250 is borrowed from the broker The investor is using leverage he is borrowing money to purchase funds However the margin in his account is the percentage of his money that he has invested Equity is ownership so it s his personal ownership of the money The percentage margin is the 750 he invested divided by 1000 of the total investment which is 75 75 of the investment is his money so this is the amount of equity that he has in the account Please associate margin with the percentage of an investor s equity This is the number one mistake the students make Margin is the collateral for the broker s loan Can be cash or acceptable securities stock bonds mutual funds or derivatives We always use cash in this class for ease of doing problems Example If you are putting up some of your money and borrowing some of the broker s money and using both his money and your money to buy stock It is the stock that is the collateral for the loan made to you Portfolio a group of financial securities Investors can hold multiple stocks in the margin account with a broker and this is their stock bond security portfolio Portfolio s Value sum of it s individual holding Value of stock 1 value of stock 2 value of stock 3 If you had bonds you would also add bond values Value of your stock holdings is the number of shares of stock you have times the price of the stock The price of the stock varies depending on its value at a specific point in time So the value of an individual s portfolio is going to vary and the percentage of equity an investor has in a portfolio will vary also Stock value price share times of shares Why do people trade on margin It magnifies gains It increases the size of your returns However don t forget that since it can magnify your gains it can also magnify your losses Example Suppose you have 5 000 to invest You want shares of ABC Stock and it costs 50 share If you don t trade on margin you can buy 100 shares If you trade on 50 margin you can use your 5000 to borrow another 5000 and buy 200 shares of stock Margin Investor s Investment Amount borrowed Total amount invested of 50 shares bought 100 5000 0 5000 100 50 5 000 5 000 10 000 200 So you have magnified your gain by 2 by using a 50 margin Advantage Magnifies profits Disadvantages Magnifies losses your borrowing money to you have to pay interest Buying on Margin on the margin loan possible margin calls Rules of Investing in Margin Must have a margin account with a broker you just trade in a margin account instead of a cash account In order to open a margin account you have to have 2 000 equity or 100 of purchase price of the stock you want to buy whichever is least This lets you borrow money from the brokerage to use for investments at the brokerage You can t borrow money to fix your house with this money You use the borrowed money to buy securities These securities are used as collateral and kept by the broker until the loan is repaid The broker will buy or sell the securities as you tell them to but they won t release the series to you or the money you get from selling them until your loan is repaid Trading in a margin account lets the brokerage safeguard the money it lends to you This is where margin calls come into play Remember you have converted cash into securities and the price of the securities can vary If I lend you 5000 you have to pay me back 5000 but if we turn 5000 into 5000 worth of the stock the value of the stock will go up or down depending on the stock price If the value of the stock gets too low you won t have sufficient margin or equity in your account as collateral for the loan because the value of your portfolio has fallen If this happens the broker will generally give you a margin call which generally allows you to add money or other securities from another account to bring the value of you margin in your account back up the where you need it to be If you don t do this the broker will sell sufficient securities in your account to cover the cost of the loan you have with them There are instances when stocks are dropping rapidly and they won t give you the courtesy of giving you a margin call You can t always count on getting a margin call it is the general way things are done but there are instances where they do not do it and it s not required that they do it Margin is the of an investor s equity and there is a minimum margin requirement that is set by the FED This is the least amount of margin that you can have in your account initially when you buy stock Brokers are not permitted to reduce the initial margin requirement lower than this The minimum margin requirement depends on the securities risk For stock the Fed sets it at 50 for bonds it s 30 minimum margin The less margin you have in the account the less collateral there is for the loan and the riskier the loan is Bonds are generally safer investments then stock so the minimum margin requirement is lower for bonds than it is for stock The brokerage house can set the margin requirement higher in other words that can require you to have greater security against the loan but they can t allow you to have less The broker s minimum margin requirement can vary Over the counter stocks stocks not listed on any exchanged are penny stocks These cannot be margined because they are so risky brokers consider them to have no collateral value Types of Margin Initial Margin minimum equity an investor must have in his account at the time of purchase Maintenance Margin minimum equity an investor must have is his account at all times you can t go below this amount this is a lower percentage of margin than the initial margin Margin Call notice that equity in an account is below the maintenance margin a courtesy Cannot be any lower than the maintenance margin at anytime Generally the brokerage gives 3 business days to return the equity back to the maintenance margin NOT the initial margin Or they will sell the holding in your account to bring it back up to the maintenance margin Restricted Margin Account equity is below initial margin required minimum amount of equity required at the time of purchase but …
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