margintrading1

What do you say when your broker offers you margin trading for your next big stock purchase? Here we look at the background to margin trading and how well it will suit you.

A customer buying something in a shop often has the choice of paying cash or purchasing on credit. Such a choice is also available to investors purchasing investment securities through a stockbroker - assuming the broker is willing to extend credit to the investor.

The investor who opts to use credit from a broker to buy securities is engaging in a practice known as "margin trading".

In a margin transaction, the investor uses money lent by a stockbroker to buy securities, and the securities act as collateral on the loan.

The margin lending limit (in other words, the proportion of the cost of the transaction that can be borrowed) will be set by the relevant regulatory agency. In the case of Hong Kong, the Securities and Futures Commission (SFC) sets a percentage limit, but the limit varies with the kind of security being used as collateral. For example, the rate for an HSI constituent stock will be lower than that applied to other riskier stocks. Also, the SFC sets the margin merely to quantify the exposure of the broker; the broker can set a higher percentage (if he wants to play safer) or a lower percentage (providing he has sufficient regulatory capital to fund the shortfall).

Although the investor can finance his stock purchase with borrowed funds, he is still required to maintain an equity position - known as the margin requirement - and he usually does this by paying an initial margin. The size of the initial margin requirement varies, but one of, for example, 40% means that the investor would have to put up 40% of the cost of the transaction, with the brokerage firm lending the 60% balance.

After the trade has taken place the stock price may well move, and this will result in a change in the margin account balance. Also, since margining introduces leverage to a position, profits or losses will accumulate faster than would be the case were the trade un-margined. For example, if the initial margin requirement is 40% then the rate of profit/ loss will be 2.5 times larger. This 2.5 is called the leverage factor; in general, the leverage factor is calculated as :
100%
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initial margin % We can illustrate this with an example.

Example of margin leverage If the initial margin is set at 40% and an investor purchases some stock for $100, the investor would pay $40, the broker would pay $60 and the broker would hold the stock as collateral. If the stock price rose to $170 and the investor decided to sell, the investor would repay the $60 to the broker and keep the balance of $110. This would represent a $70 profit on a $40 investment -- a return of 175% as opposed to one of 70% had the purchase been entirely financed by the investor. 175% is 2.5 times greater than 70%, so 2.5 is the leverage factor.

If the price of a stock which has been bought on margin falls, there is a danger of the investor defaulting and leaving the broker to realise the loss. To guard against this situation and to protect himself, the broker usually requires a maintenance margin.

The maintenance margin is the point at which the stock price has fallen so far that the investor needs to pay additional initial margin. Let's say the maintenance margin is set at 25%. As soon as the stock price falls to the level where the margin account equals just 25% of the price (or the loan from the broker equals 75% of the price), the investor must top up the margin balance so that it reaches the level of the initial margin of the new stock value. Again, in some overseas countries the regulatory authorities set the maintenance margin, but in Hong Kong this is not the case. The price that will trigger a margin call for a long position is represented by the following formula:

(original price) x (1-initial margin)
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(1-maintenance margin) [where initial and maintenance margins are represented in decimal form]

To summarise, margin trading involves buying securities with borrowed money. It can be attractive to investors as they will enjoy an element of leverage; however, in a falling market, margin calls can be a regular occurrence.