Financial Markets For The Rest Of Us
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
interest payments as long as you use it. Then there is the variable factor. As it was previously explained the amount of margin allocated to an account is proportional to the account's equity.As the amount of equity varies, perhaps due to stock price variations, deposits, and withdrawals, the amount of allocated margin varies accordingly.
Let us go back to our example to illustrate the point. Suppose you opened your account with $1,000 cash and your broker allocated your account $1,000 in margin (50% ratio rule). Now you go ahead and buy 20 shares of Ford at $50 per share.You now have spent all your cash (we are omitting fees and commissions in our example). But your equity is still $1,000 at the moment of your stock purchase so your margin allocation is still $1,000. This means that broker is giving you a $1,000 credit to buy stocks with. Suppose now that Ford stock rises to $60 per share. Your equity climbs to $1,200 and respectively the amount of margin will also climb to $1,200. Conversely if Ford stock drops to $40 per share, your margin allowance will decrease to $800. At this point you may wonder if one doesn't use the allocated margin, who cares how much it stands at. And you would be right. If you only trade with your cash and don't buy on margin, there is no need to concern yourself with the margin amount, and you would only need to track your equity. But some investors do buy on margin in order to use an important tool: leverage. In the world of stocks leverage means an advantage gained through borrowed money. In this case, the borrowed money is the margin that your broker has allocated you and the advantage is having more shares of stocks.
Of course there is no such thing as gaining advantage without risk. Let us illustrate this through our example. Previously we used the Ford stock example showing that if you buy 20 shares of Ford at $50 for $1,000 and the stock rises to $60, you stand to gain $200 in profit. If you had decided to use your full margin amount initially, you could have …
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