Margin Trading Strategies
Margin is the use of leverage in order to increase the rate of return on an investment. Margin is also debt that accrues at a rate of interest. Margin may affect the kinds of quality in a trader's investment strategies. Traders should use margin sparingly and only for trading situations in which profitability is enhanced by a multiple of the rate of interest to compensate for the amount of risk employed.
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Margin Trading Strategies For Bonds
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Note that the rate of the cost of margin will always affect a trader's strategy. Assume bond rates are peaking. Consequently, because margin debt is priced daily, it is to the advantage of the bond trader to margin when there is the expectation of paying a lower rate in the future. Buy corporate or mortgage backed bonds trading at a discount and at a rate equal to or below the margin rate. Capture the net coupon difference between the bond and the margin rate. In addition, as rates fall, bond prices rise and the trader reaps capital gains from the rise in bond prices. Bonds can be leveraged by a multiple of the cash down payment.
Margin Strategies for Stocks and their Derivatives
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While high yielding stocks can be margined like bonds, the amount of margin is severely limited to only 50 percent of the amount pledged. Consequently, stock leverage should be avoided. Instead of buying stock, buy long term appreciation options known as LEAPS. Depending on the strike price of the option, leverage will be between two and five times the price of the stock. LEAPs do not pay stock dividends, but move dollar for dollar with the increase in the value of a stock. Because LEAP expiration dates are usually two to three years in the future, they will still maintain value even if the stock price deteriorates.
Margin Strategies for Stock Futures
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Rather than buying individual stocks, consider the very volatile and highly (10 times or more) leveraged possibility of trading futures. Futures representing the major indexes are liquid and easily traded. Requirements include the ability to deposit an initial margin amount for the contract purchased and additional funds called maintenance margin in case the trade works against the investor. Profitability possibilities are huge because depending on the contract margin, the trader will be effectively owning several hundred thousand dollars worth of stock. Risks are substantial, and this strategy must always be closely monitored.
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