Question

How do margin trades magnify both the upside potential and the downside risk of an investment position? Explain your answer with an example.

Answer 1

Margin trade the is a act when a trader buys more stocks than the money available in his trading account. For this kind of act, brokerage firm allows a trader by giving some benefits in the trading account by providing margin for purchasing securities in trader account and it is provided by brokerage firms based on the trader profile and type of accounts (margin accounts) they use. In simple words, if a trader having shortage of funds for purchasing XYZ securities, brokerage firms allows by giving some funds to the trader based on his capacity. Sometimes a trader may borrow the funds from borrower. Margin rates depends on the broker to broker and type of segments of trades which is not exceed by board of exchange rates

For example:

If XYZ broker provides $2000 margin (% is specified in some cases) on equity market for intraday tade.

ABC company having share price of $10  and Mr. Khan having cash in trading account of $ 3000 so he can now purchanse shares worth $5000. Mr. Khan able to purchase now 500 shares of ABC company and share price becomes after some time during market hours $15 and sold immediately. Thereafter, Mr. Khan will be in a profit of $5 per share which is $ 2500 (500*$5). So Mr.khan will book the profit in his accounts of $2500 and again $ 2000 returned to margin account now Mr.khan will have total $ 5500 as cash in his account.

So here we can see upside potential while having profits in magin trade

Taking same above example if share price of $10 becomes $5 during market hours after puchased by Mr.Khan and he was not willing to loose more value of the stock and sold immediately for $5. Now Mr.Khan has sold the stock for declining value and he has booked loss now, where he has lost of $2500. Now here is problem as Mr. Khan looses nearly 83% of value as now he his having only $500. Since, 500 shares sold for $5 which comes to value $2500 and having booked loss of $2500 and now only $500 remains with him as cash in his accounts and $2000 will returned to margin account.

So here we can see the risk is more with the downside of investment in margin trade. The loss may be more than 100% and some times goes to negative balance.