CM

Lecture 43: Trading 2

Investment Analysis: Trading and Order Instructions Pt. 2

Overview of Margin Transactions

Margin transactions enable investors to enhance their buying power by borrowing funds, which can maximize returns but also elevates risks, including margin calls.

Leverage in Trading

  • Investors can either pay fully in cash or use leverage by borrowing from brokers, increasing both potential returns and risks.

  • Understanding margin mechanics and associated risks is essential.

Key Concepts

  • Margin Requirement: The percentage of the total transaction value that must be covered with cash, typically ranging from 40% to 100%.

  • Investor Equity: Defined as the ownership value in stock; calculated with the formula: Equity = P × Q - L (P: stock price, Q: quantity, L: loan amount).

Stock Price Changes

  • If prices rise, the investor's equity increases. If prices fall, risk of losing equity rises, potentially triggering a margin call.

Types of Margin Requirements

  • Initial Margin: Proportion of equity needed at the start. Example: For a $50,000 stock purchase at 50% margin, $25,000 cash is needed.

  • Minimum Maintenance Margin: The minimal level of equity post-transaction needed to avoid a margin call.

Case Study: Buying on Margin

  • Buying 200 shares at $50 each costs $10,000, needing an initial cash investment of $5,000 and a $5,000 loan.

  • Price Increase: If the stock rises to $60, total value is $12,000, with equity at $7,000 (58.33% of total value).

  • Leverage Impact: Losses amplify similarly; a drop to $40 leads to a -40% return on initial investment.

Costs and Net Returns

  • Transaction costs reduce net returns; for example, interest and commission can lower expected returns significantly.

Margin Call Price Calculation

  • Mandatory to manage risk. For a $5,000 loan, 200 shares, and a 25% maintenance margin, the margin call price is set at $33.33.

  • If the stock drops below this price, additional funds may be needed to avoid liquidation.

Final Takeaways

  • Understanding margin dynamics, monitoring costs, and being aware of margin call prices are crucial for sustainable trading.