In stock investment, your margin is made up of the value of shares you own, typically minus a certain percentage (30%, for example) to allow for possible fluctuations in the value of shares. For example, if the current value of your shares is 1000 Swiss francs and your broker uses a 70% margin, then your margin would be 700 francs. That means your broker would give you a 700-franc revolving loan which you could use to make further investments. If the value of your shares were to suddenly fall to 800 francs, your collateral would still be sufficient to cover the loan because the broker initially undervalued your collateral by 30%.
When the value of the assets which collateralize a margin falls, the margin is no longer be sufficient to cover the loan. If the loan is unused, it will simply shrink to match the new margin. If the loan is used, the portion of the loan which is not covered by the margin must be covered by cash in your brokerage account.
If there is not sufficient cash in your account to cover the difference between your margin and the loan provided by your broker, the broker would make a margin call. This means that the broker would ask you to deposit more cash into your account to make up for the deficit in your margin. If you fail to deposit more cash by the broker’s deadline, the broker will sell your assets to recover all or part of the loan principal. If the sale of the assets is not sufficient to cover the loan, you will owe the broker the difference.
Margins are particularly important when you trade using leverage, as is common in forex trading and CFD trading. The reason for this is that leverage multiplies losses in the same way that it multiplies gains. For example, if you buy stocks using a leverage ratio of 1:10, your broker is lending you 10 Swiss francs for every 1 franc of collateral in your margin. If the value of your assets goes down, you will need 10 times the amount of cash in your account to compensate for the difference than if you did not use leverage.
To avoid losses, you should take care to always have sufficient cash in your brokerage account in addition to your margin to cover all possible fluctuations in the value of your positions.
The terms trading on margin and margin trading refer to the practice of using loans provided by brokers and secured by a margin to make additional investments rather than using cash.
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