When opening an account to trade stock with a broker an investor would typical utilise a cash account.
Trading on a cash account basis requires full funding to be available to cover the cost of the purchased security, plus commission prior to settlement of the trade. Sales proceeds are immediately credited to the cash account upon settlement.
Investors wishing to leverage their asset position in their brokerage account can open a margin account. A margin account is a brokerage account which permits investors to borrow cash from the broker to cover the purchase of securities using the securities in the account as collateral. Interest is charged by the broker on the amount borrowed and the investor must maintain sufficient collateral as coverage for the loan.
In order to open a margin account, the investor executes a margin agreement with the broker which defines the terms and conditions of the account. A minimum cash deposit is required to open a margin account – this is known as minimum margin.
Once the account is open, the broker will allow the investor to borrow a certain percentage of the value of the stock to be purchased. Market regulators typically set this percentage limit and the broker is entitled to have stricter limits than the regulator, but not more lenient.
In the United States the borrowing limit is 50 percent of the securities to be purchased. If the investor wishes to purchase a security for US$100,000, then $50,000 in cash would need to be deposited in the account. This is known as initial margin.
In this case the investor would have a security position worth $100,000 and a loan from the broker of $50,000. The security acts as collateral for the loan. The regulators and broker determine which securities qualify as suitable collateral; penny stocks and initial public offering securities are normally not accepted.
Once the position is open, the investor is required to keep a minimum amount of net equity value in the account - this is known as the maintenance margin requirement. The maintenance margin requirement is normally lower than the initial margin requirement. For example in the US it is 25 percent. The net equity value in the account is calculated by subtracting the borrowed amount from the value of securities in the account. If the securities purchased for $100,000 now have a market value of $60,000, then the net equity in the account would be $10,000.
Assuming a maintenance margin requirement of 25 percent, the net equity requirement would be $15,000 (25 percent of $60,000). In this case the investor would receive a margin call from the broker requiring an immediate deposit of cash of $5,000 or other collateral to fulfill the net equity requirement.
If the security increases in value, say to $120,000, the investor may sell at a $20,000 profit and pocket a gain of 40 percent ($20,000 gain on a $50,000 investment). Interest costs would decrease the overall gain.
Leverage through margin trading can magnify profits and losses. It requires skill and experience and should only be employed by professional investors.
Anthony Galliano is Chief Executive Officer at Cambodian Investment Management.