Leverage and Buying Power
Leverage & Buying Power
To illustrate how buying power works, say that you deposit $4000 into your margin account. Since your margin account allows you to borrow up to 50% of the purchase price of a stock, you actually have the purchasing power to buy $8000 worth of stock.
Note that you are not required to fully leverage your investment. You have the choice to use margin up to 50 percent, but you can choose to use a smaller amount of margin and more of your own cash.
Let’s assume that you believe that a stock is going to be very successful, so you use all $8000 of your buying power to invest in the stock. Shortly after, the value of your investment increases to $10000. With margin, this provides you with a 50 percent return on investment (10000-4000-4000)/4000 versus a 25 percent return if you had only used your own cash (5000-4000)/4000.
On the other hand, if your investment decreased in value to $6000, then you would take a 50 percent loss instead of a 25 percent loss because $4000 will need to be paid back to the brokerage. This is how investing on margin magnifies the potential gains and losses on your investment.
There are a few special limitations and risks tied to margin accounts: maintenance requirements, margin calls, and liabilities associated with maintaining a margin account.
Before you trade with a margin account you first must meet the minimum margin balance requirement of $2000. Once this has been met, you may borrow up to your initial margin, which is 50 percent of the purchase price of a stock.
After you purchase a stock on margin, you are required hold to a maintenance margin which is an equity balance of at least 25 percent of the total market value of the securities in your margin account. Your equity balance is calculated by subtracting your borrowings from the value of your securities. If your maintenance margin drops below the required level, your financial institution will warn you that you need to deposit more cash or securities into your account. If you fail to meet the margin call, your brokerage will liquidate as many of your securities as needed until the maintenance margin is met. This is an example of how your stocks are used as collateral and how you could suffer large losses or missed opportunities as a result of your liquidated positions.