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Margin trading: A double-edged sword

03 Mar 2014 - {{hitsCtrl.values.hits}}

Imagine you’re sitting at the black jack table and the dealer throws you an ace. You’d love to increase your bet but you’re a little short on cash. Luckily, your friend offers to spot you Rs.50 and says you can pay him back later. Tempting, isn’t it?

If the cards are dealt right, you can win big and pay your buddy back his Rs.50 with profits to spare. But what if you lose? Not only will you be down your original bet but you’ll still owe your friend Rs.50. Borrowing money is like gambling on steroids: the stakes are high and your potential for profit is dramatically increased. Conversely, your risk is also increased.

Margin is a high-risk strategy that can yield a huge profit if executed correctly. The dark side of margin is that you can lose your money. One of the only things riskier than investing on margin is investing on margin without understanding what you’re doing. This article will enable you to manage your margin account wisely.

Margin trading: What is buying on margin?
Buying on margin is borrowing money from a broker to purchase stocks. A stockbroker firm may extend credit to its clients for the sole purpose of purchasing securities traded on the Colombo Stock Exchange (CSE), provided that the total value of the credit extended shall not exceed three times of the ‘adjusted net capital ’ of the stockbroker firm.

Margin trading allows you to buy more stocks than you’d be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account. By law, the stockbroker firm is required to obtain your signature to open a margin account. The stockbroker firm should enter into a written agreement with each client to whom credit is extended, which clearly sets out the terms and conditions entered into between the parties. Every amendment to such agreement shall also be in writing.

The margin account may be part of your standard account opening agreement or may be a completely separate agreement. An initial investment is required for a margin account. This deposit is known as the minimum margin.

You can keep your loan as long as you want, provided you fulfil your obligations. First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid.

Second, there is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it’s known as a margin call.

Borrowing money isn’t without its costs. Regrettably, marginable securities in the account are collateral. You’ll also have to pay the interest on your loan. The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on.

Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater the return that is needed to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.

As a rule of thumb, it is best to refrain from penny stocks (low market capitalization, highly liquid, speculative stocks) and Initial Public Offerings (IPOs) on margin because of the day-to-day risks involved with these types of stocks.

Let’s say that you deposit Rs.10,000 in your margin account. Because you put up 50 percent of the purchase price, this means you have Rs.20,000 worth of buying power. Then, if you buy Rs.5,000 worth of stock, you still have Rs.15,000 in buying power remaining. You have enough cash to cover this transaction and haven’t tapped into your margin. You start borrowing the money only when you buy securities worth more than Rs.10,000.

This brings us to an important point: the buying power of a margin account changes daily depending on the price movement of the marginable securities in the account.

(To be continued next Monday)
(Source: Investopedia)

Features

Margin trading: A double-edged sword

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