Margin Buying

§  Basically margin buying is using borrowed money to purchase stocks (or other investments)

§  You’re taking out a loan to buy investments

§  Also called leverage buying

§  When you buy stocks “on margin,” you expect them to increase in value

§  You borrow the money from your broker

§  You either don’t have the cash or it’s tied up in other investments you don’t want to sell

§  You are charged interest on the amount you borrow

§  You may only borrow 50% of the purchase price

§  Example: if you want to buy 100 Aliant shares at $20 each ($2000), you must put up $1000 of your own money.

§  At some point, the loan must be repaid

§  Margin buying is a risky strategy that requires close (i.e., daily) monitoring of stocks

If the price rises:

§  Your strategy worked; hopefully you will have made enough money on the stock to more than cover commissions and interest on the loan.

If the price drops:

§  Using the above Aliant example, assume the share price drops to $15. Since your broker lent you $1000 and the broker’s share of your investment is now worth only $750 ($15 X 100 shares X 50%), you owe your broker $250. You get a “margin call” – your broker calls you to demand the $250.

Equity Margin Buying

Stocks trading at less than 3.00 per share cannot be margined.

When buying on margin, the investor is expecting the stock to rise in price and wants to use leverage to purchase the stock. When using leverage, the investor is only paying a portion of the total purchase price, while the broker lends him the remainder. Margin is the amount paid by the investor when the balance is loaned by the broker. The investor must pay interest on the funds advanced by the broker. This margin interest will be calculated each daily and will appear on the Portfolio Summary. The commissions charged by the broker are charged on the full amount of the purchase.

Buy on Margin and Sell a Margined Stock

The investor is expecting the stock to rise in price and is using leverage by only paying a portion of the total purchase price of the stock, while the stock broker lends the remainder. Interest on the amount loaned (the margin) will be calculated and applied each time a portfolio report is produced. The brokerage commission is charged on the entire amount of the purchase.

The investor sells a margined stock at its market price. The proceeds from this sale of stock will first be applied to repayment of the margin amount provided by the broker at the time of the stock purchase. The balance of those funds (less commission) will be transferred to your cash account.

Why use margin?

The primary advantage of buying stock on margin is leverage - it allows investors the opportunity to purchase more stock than they actually have cash to pay for. With 50% margin requirements, an investor can make his money go twice as far.

An Example: You have $2,500. You could do a straight buy and sell of 100 shares of XYZ at $20.00 per share. Your purchase cost would be $2000. If you sold the 100 shares at $25 per share your proceeds would be $2500 minus brokerage fees. Your profit in this example would be $500 less whatever the brokerage fees were to buy the stock and to sell it.

Or, you could buy and sell using margin. If you buy XYZ at 50% margin you would still pay $2000 but now your broker would also put up $2000. You would then have 200 shares of stock worth $4000. If the value of XYZ increases to $25 per share your 200 shares would be worth $5,000 and your profit would be approximately $1,000 (minus the brokerage fees of course).

To sell the previous example of margined stock use the trade request sell margin, 200, XYZ. This will reduce your margin loan by the amount margined and add the proceeds to your CASH position.

Clearly, buying on margin affords the investor the opportunity to realize greater profits. It should be stressed however that the opposite also holds true in that a decline in stock prices effectively doubles one's losses.

Margin Calls Margin calls will occur when the stock price changes either up or down. Margin calls will be reflected on the Margin Change Report. If the price of the stock decreases in value a margin call will be issued to the team by the broker asking for more money to reduce the margin loan. If the price of the stock increases in value the broker extends the amount of the margin loan allowing more money to invest. The reasons for these two quite different margin changes are explained below. Most brokers will allow at most a 50% margin. See below for examples

Following this 50% margin rule, we can see that the ratio is:

If this ratio changes, the investor will potentially receive a margin call, a request from the broker for cash to restore the ratio to 50%.

An Example of the 50% Margin Rule

In order to illustrate margin changes numerically, consider the following:

- the investor has $10,000 cash

- the computer broker lends the investor an additional $10,000

- the stock price for LMN is $40/share

Therefore,

Market Value - Margin Loan x 100 = 50%

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Market Value

AND

$20,000 - $10,000 x 100 = 50%

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$20,000

Using the preceding example, what happens to your margin loan when the price

of LMN stock falls from $40 to $30 per share? Remember, the 50% rule must

still be met.

New Market Value - Margin Loan x 100 = 50%

------

New Market Value

BUT

$15,000 - $10,000 x 100 = 33 1/3

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$15,000

Since the ratio is no longer 50%, the investor will receive a margin call for an amount that will restore the equity with the new market value of the margined stock to the 50% rate. In the above example a margin call for $2,500 will reduce the broker's loan from $10,000 to $7,500 and return the value of the current equity to 50% of the current market value. The $2500 will be taken from the team's cash, leaving less cash for further investing.

Let's use the preceding example and see what happens to the margin loan if the price of the stock goes up. Initially, all was in order because the 50% rule was met. The price of LMN stock now rises from $40 to $50 per share. The 50% rule must still be true.

New Market Value - Margin Loan x 100 = 50%

------

New Market Value

BUT

$25,000 - $10,000 x 100 = 60%

------

$25,000

Since the ratio is no longer 50%, the investor will have the margin loan extended to $12,250 and will have the difference between the previous margin loan and the extended margin loan deposited into CASH. That will restore the equity with the new market value of the margined stock to the 50% rate. In the above example the margin loan was extended by $2,500 and $2,500 was added to the Cash account. The investor now has more cash available for future investing.