Margin is a way of increasing your purchasing power for investments. Buying on margin means that you take a loan from your broker to increase the amount of funds you have at your disposal to invest. The loan comes with its own costs in the form of interest and there are limitations on how you use the loaned funds.
When an investor uses the funds of the broker, the returns that he makes on the investment are ‘amplified’ because his own money used in that trade is much lower than the actual invested amount.
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Chapter 1: Example of Margin Trading
You have $500 to invest and are interested in the shares of Kramer’s Sports Shoes, selling at $20 a share. If you use only your own funds to make the investment, you can buy 25 shares of the company. But you decide to get your broker to lend you another $500. You can now buy 50 shares with an initial investment of just $500 from your side.
Let’s say Kramer’s Sports Shoes has been designated the official shoes for the Olympics and the stock price goes up to $40. If you had invested only your own $500, your investment would now be worth 25 shares x $40 = $1,000. Your return on investment in this case will be 100%.
But as you had bought the shares on margin, adding the broker’s $500 to your own funds, your investment is now worth 50 shares x $40 = $ 2,000. You have doubled your investment’s value with an outlay of the same $500 from your side.
Of course, you will still have to pay back the $500 plus interest and other applicable charges on the margin, but even after deducting that amount, you will be left with much more profit than you would have if you had not used margin. Your return on investment in this case will be 200%.
This example shows how using margin at the right time and with the right investments can multiply the gains you stand to get with your investment. However, the most important thing to understand about margin trading is that it not only amplifies your gains, but also your losses.
In the same example, if the stock price had fallen, you would lose much more when you use margin trading. This is the reason why margin trading is considered quite risky (more on this in the section on risks).
Next Chapter: Margin Trading Terminology