Stock market and trading are not as linear as they appear, especially the derivative markets. There is a need to diligently manage funds, more importantly margins. Margins refer to the amount of money an investor needs to maintain in the trading account to be able to perform a trade. Different stock trades and derivative contracts have different margin requirements. Let us dive deeper into what margin is and its nuances.
This article covers:
What is margin?
Margin is the measure of cash that investors store with their broker or exchange to cover the credit risk the holder poses to the broker or the exchange.
When an investor borrows cash from its broker to buy financial instruments, borrows financial instruments to sell them short, or engages in a derivative transaction, he or she is taking credit risk. A margin call is a situation when the value of the margin account falls below the account’s maintenance margin requirements.
A brokerage firm requires a margin account’s balance to be brought up to the required minimum maintenance margin. To meet a margin call, the margin account’s holder must either deposit more money, deposit non-marginable securities, or liquidate current assets.
A margin account is the brokerage account in which the broker lends the investor money so that they can buy more stocks than their account balance allows. When you buy stocks on margin, you’re effectively utilising the cash or assets already in your account as collateral for the loan. Because the investor is borrowing money or utilising leverage, the investor’s losses and gains will be magnified.
Margin investing may be an advantage when an investor anticipates earning a higher rate of return on his investment than what he is paying in interest on the loan.
Buying on margin
Purchasing stock on margin entails borrowing money from a broker. Margin trading permits you to purchase more shares than you would ordinarily be able to. This is not the same as a traditional cash account, where you trade with the money in the account.
There’s also a maintenance margin requirement, which is the minimum account balance investors must maintain before their broker will force them to deposit more funds or sell stock to pay off their loan.
A margin call is a request from the brokerage for you to deposit funds or sell off holdings in order to bring your margin balance to the appropriate level. If you fail to meet the margin requirement, your brokerage firm may cancel any open positions in order to restore and maintain the account to its minimal value. Your brokerage firm has the authority to liquidate positions without your permission.
Investors are also charged a commission by your brokerage firm for the transaction. Your brokerage business may liquidate shares or contracts to exceed the initial margin requirement.
How to avoid a margin call?
Keep a cash reserve in your account
Instead of putting all of the money into financial instruments, the investor can put some money aside in cash to avoid margin calls. Cash offers a stable value that will not change even if the value of other assets fluctuates.
Plan for volatility
By holding various types of securities, an investor can diversify his or her portfolio. A diverse portfolio can help an investor tackle the ups and downs of the financial markets without falling below the maintenance margin.
Invest in assets with high return potential
High-return investments can help investors make adequate short-term returns. Investing in short-term assets with a high return potential can allow an investor to make enough money to cover the margin loan and interest while still making a profit.
Make regular payments
Every month, interest is charged to the investor’s account. Because margin loans do not have a set payback timetable, the investor must devise a strategy for paying interest charges on a regular basis. Making monthly interest payments will help you avoid loan buildup and keep your loan balance under control.
Set an investor’s minimum
Investors must choose a maintenance margin that is higher than the broker’s minimum balance requirement. When the margin account balance falls below that limit, the trader should top up the account to bring it back up to par. An investor can use this method to prevent margin calls and forced sales of high-potential equities.
Margins requirements form an important part of many derivatives and financial instruments. Investors can face acute losses if they do not understand the concept of margins. Contact your financial planner before investing in any financial instrument.