Defining a Purchasing Margin
A purchase margin in the equities and futures market is the amount of money an investor must provide to open a position using margin credit provided by his brokerage firm. Since purchase margin is only used to open a position, it is more often referred to as initial margin. Essentially a down payment on the overall value of the position, purchase margin amounts vary from futures contract to futures contract. However, buying stock on margin always requires a 50 percent purchase margin.
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Significance
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Trading on margin enables investors to increase the potential gains and losses of their investments through leverage. By borrowing money to invest, an investor makes a much greater percentage return on his investment if the investment appreciates in value. However, if the investment drops in value, the investor can lose all the money he invested plus all the money he borrowed.
Function
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When buying a stock on margin, the investor must fund 50 percent of the total investment initially. For example, if XYZ is trading for $50 a share and an investor wants to buy 100 shares on margin, he must provide $2,500 in purchase margin ($50 x 100 shares = $5,000 x 50 percent = $2,500). The investor pays interest on the $2,500 he borrowed, and if XYZ drops in value he may be required to add more money to maintain the position (maintenance margin).
If XYZ goes to $75 per share and the investor sells it, he makes a $2,500 profit on a $2,500 investment (minus interest on the money he borrowed, of course) after repaying the loan amount. Had he paid cash for the stock initially, he could have only purchased 50 shares of stock and would have only made a $1,250 profit on the trade when he sold the stock for $75.
Types
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The two main types of margin investing are stocks and futures. With purchase margin, stocks afford 2:1 leverage (the investor must open the position with a 50 percent down payment). In the futures market, the leverage is much greater. The individual futures exchanges determine the initial and maintenance margin amounts for each individual commodity. It is possible to leverage a commodity investment at 20:1 or more.
Considerations
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Since margin trading, whether stocks or futures, requires a large degree of sophistication, individual investors must be approved to trade on margin by their brokerage firm. Since margin is an extension of credit, brokerage firms do everything they can to limit their risk. Margin requirements are in place to ensure that investors can't borrow more than they could afford to repay.
Warning
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Trading on margin, especially futures trading, can be extremely risky. When trading on margin, losses are compounded by an investor's lack of liquidity. If an investor cannot afford to add funds to maintain a margin position, the position must be sold at a loss and the borrowed funds repaid with interest.
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