Margin trading is the practice of buying securities using money borrowed from a broker. Securities owned by the investor form the collateral which secures the loan. The higher the value of the securities owned by the investor, the larger the margin available to the investor will be and the more money they will be able to borrow.
Margin trading allows investors to make large investments without tying up large amounts of capital because part of the investment is funded by a loan. If the value of investments falls to the point that an investor’s deposits no longer provide full collateral against the loan, the broker will use cash held in the brokerage account to make up the difference.
If there is not sufficient cash in the account to cover the difference between the value of the collateral and the money owed, the broker will exercise a margin call. This is a demand to the investor to replenish their margin by depositing more money into their brokerage account.
Example: An investor purchases 500 shares worth 50,000 Swiss francs using the cash available in their brokerage account. The broker offers the investor a margin equal to 70% of the value of their shares (to allow for losses in share prices), or 35,000 francs. The investor uses the 35,000 francs from their margin to buy an additional 350 shares.
If the value of the investor’s shares were to go up by 5 francs per share, the investor could sell all 850 shares at a profit of 4250 francs. If the value of the shares were to go down by 5 francs per share, the investor would have to deposit 1750 francs (5 francs for each of the 350 shares purchased on margin) into their brokerage account to replenish their margin.
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