What is Buying on Margin?

Buying on Margin is defined as an investor who purchases an asset, say stock, home, or any financial instrument, and makes a down payment, which is a small portion of asset value. The asset purchased will serve as collateral for an unpaid amount. The balance amount is financed through a bank or brokerage firm loan.

Buying on Margin Example

  • Consider an investor who contacts his broker to buy two December gold futures contracts. Suppose that the current future price is 1,250 per ounce and the contract size is 100 ounces. The Initial Margin is 6000 per contract or 12000 in total.Suppose now by the end of the first-day future price has dropped by$9 from 1,250 to 1,241. As a result, an investor has incurred a loss of 1,800 (200*9) because now 200 ounces of gold, which the investor contracted to buy at 1,250, can be sold for only 1,241. Therefore, the balance of the margin account would be reduced by 1,800 to 10,200(12000- 1800).Similarly, if the price of December gold rose to 1,259 by the end of the first day, the balance in the margin account would be increased by 1,800 to $13,800(12000+1800).

Characteristics of Buying an Asset on Margin

  • A margin account is adjusted to reflect investor gain and loss at the end of each trading day. This practice is referred to as daily settlement orMarking to market (MTM) is the concept of recording the accounts, i.e., the assets and liabilities at their fair value or at the current market price, which varies with time rather than historical cost. It helps to represent the company’s actual financial condition.read more marking to marketMarking To MarketMarking to market (MTM) is the concept of recording the accounts, i.e., the assets and liabilities at their fair value or at the current market price, which varies with time rather than historical cost. It helps to represent the company’s actual financial condition.read more.To satisfy the margin requirement, an investor usually deposits securities with the broker, such asTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more treasury billsTreasury BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more for about 95- 100% of face value stocks for about 50-70% of their face value.Margin requirements may depend on the objectives of the trader. A hedger such as a company that produces the commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more on which the futures contract is written is often subject to lower margin requirements than a speculatorSpeculatorA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more due to fewer default risks.Day trades and spread transactions often give rise to margin requirements. In a day trade, a trader announces to the broker to close out the position on the same day. In a spread transaction, the trades simultaneously buy a contract position on an asset for one maturity month and sell a contract on the same asset for another maturity month.The exchange sets up margin requirements in aDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more such as the future. Individual brokers may require a greater margin from their clients than those specified by the exchange.Margin levels are determined by the variability of the price of an underlying assetAn Underlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more, i.e., the higher the variability higher is the margin levels.

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Types of Buying on Margin

Let’s discuss the following types.

  • #1 – Initial Margin – The amount that must be deposited at the time when the contract is entered into is known as the Initial MarginInitial MarginInitial margin refers to the equity to be contributed by the investor trading on margin to the margin account, and it is expressed as a percentage of the total purchase price. read more.#2 – Maintenance Margin – The investor is entitled to withdraw any balance in the margin account over the Initial Margin. To ensure that sufficient funds are available in a margin, a maintenance margin is set, which is lower than the Initial Margin.#3 – Variation Margin – If the investor fails to keep balance in the margin account as a result of which funds fall below the maintenance margin, the investor receives a margin call and is entitled to bring the margin account equal to the initial Margin by the end of the next day. The extra funds deposited are known as variation margin.#4 – Clearing Margin – Just as an investor is required to maintain a margin account with the broker, the broker is also required to maintain a margin account with clearing houseClearing HouseA clearinghouse is a mediator between two firms (which may or may not know each other) that are engaged in a financial transaction (wherein one party is a buyer & another party is the seller in the said transaction), taking the exact opposite positions for each firm and ensures that there is no risk of default in the transaction.read more members, and the clearinghouse member is required to maintain a margin account with the clearinghouse which is known as clearing Margin.

Advantages

Disadvantages

  • The main disadvantage of buying an asset on a margin is that losses may also magnify. Consider the above example, if your stock instead goes down from $20 per share to $10, now the value of an investment is worth $1000, which is equivalent to a margin loan of $1000, so the entire investment is lost, leaving an investor with zero return.An interest charge is also a significant concern. An investor needs to pay the interest on the money borrowed from a brokerage firm, so there is pressure on him to earn more than to cover interest payment as a result of which he might invest in a risky asset that offers a higher return but comes with higher risks too.

Conclusion

Margins are an essential aspect that allows a trader to trade in various financial products, such as futures, options, and stocks. Buying on Margin involves a minimum investment amount deposited in a margin account and allows a trader/investor to borrow the balance from a broker. The account is adjusted daily to reflect gains and losses.

This article has guided what is Buying on Margin & its Definition. Here we discuss the buying on margin types characteristics and the example, advantages, and disadvantages. You can learn more about from the following articles –

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