Financial Markets For The Rest Of Us|
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
purchased 40 shares of Ford stock at $50 per shares: 20 shares with your money and 20 extra shares with the $1,000 margin. Selling all 40 shares at $60 per shares will yield you $2,400. Pay off the original $1,000 margin and that would yield $1,400 for a profit of $400. Twice the $200 profit had you not bought on margin, excluding fees, commissions, and interest on margin. This is the power of leverage at work. By buying on margin you were able to double your profits. In this example we maxed out on our margin buying power, using the entire $1,000.
It is always up to you to decide how much margin you want to use: from nothing to a quarter to a half to all, it's your choice. One more interesting thing to observe here is as your equity climbed to $1,400, you would have had an extra $400 margin in your account on top of the original $1,000. The margin amount always maintains its relation to your equity.
Well this was the good news about leverage. Now the bad news. Suppose that Ford stock fell to $35 per share. The value of your holding would now be
40 shares x $35 per share = $1,400
But remember that $1,000 of this amount is margined, so your equity is now actually $400, which would put your equity to holding ratio at about 28%. If you had not bought this stock on margin you would have had 20 shares with the value of $700. You should be able to see the danger of leverage here. Just as you were able to double your profit in good times, you could double your losses in bad times.
At this point if you decide to cut your losses and sell, you would end up with $400 and your original margin loan would be paid back. Of course, now that your equity has dropped to $400, your margin will also …
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