How Securities Are Traded

Margin buying of common stocks (Levered position)

Buying stock on margin means buying stock with partially borrowed funds. These funds are
borrowed from your broker, who has borrowed the funds from a commercial bank. The borrowed
money is called the margin loan, and they are said to buy on margin.

The interest rate that the buyers pay for their margin loan is called the call money rate. The call
money rate is above the government bill rate and is negotiable.

Trader’s equity is that portion of the security price that the buyer must supply. Traders who buy
securities on margin are subject to minimum margin requirements. The initial margin
requirement is the minimum fraction of the purchase price that must be trader’s equity. It is the
percent of the funds that must be your own. The current initial margin requirement is 50% and is
set by the Federal Reserve System.

Margin is simply equity as a percent of the value of your account. Subsequent to opening
the account, stock prices change and thus the margin of your account changes.

Buying securities on margin can greatly increase the potential gains or losses for a given amount
of equity in a position because the trader can buy more securities on margin than he could
otherwise. The buyer thus earns greater profits when prices rise and suffers greater losses when
prices fall. The relation between risk and borrowing is called financial leverage (often simply
called leverage)

The leverage ratio is the ratio of the value of the position to the value of the equity
investment in it. The leverage ratio indicates how many times larger a position than the equity
that supports it. The maximum leverage ratio associated with a position financed by the
minimum margin requirement is one divided by the minimum margin requirement. If the
requirement is 40 percent, then the maximum leverage ratio is 2.5 = 100% position ÷ 40%
equity.
The leverage ratio indicates how much more risky a leveraged position is relative to an
unleveraged position. For example, if a stock bought on 40 percent margin rises 10 percent, the
buyer will experience a 25 percent return on the equity investment in her leveraged position. But
if the stock falls by 10 percent, the return on the equity investment will be 25 percent (before the
interest on the margin loan and before payment of commissions).

The maintenance margin is the relevant margin after you open your account. To prevent such
losses, brokers require that margin buyers always have a minimum amount of equity in their
positions. This minimum is called the maintenance margin requirement.

A 25% maintenance margin is required for NYSE listed stocks; however, most brokers will
require a maintenance margin above that amount. If the margin of your account falls below the
maintenance margin requirement, you will receive a margin call. You can either send your
broker more cash to reduce the amount of the original loan to get your account back to the
required maintenance margin, or your broker can sell some of the shares for you, using the
proceeds to reduce the amount of your original loan, thus getting your account back to the
margin requirement. If the price of the stock increases, your account will become over margined
and you can either pyramid (buy more shares without using any of your own cash) or you can
withdraw cash from the account(increasing the amount of the loan). If you execute either of these
actions, you must not let your account fall below the initial margin requirement (increasing the
number of shares or the amount of the loan requires the account to be treated as a new account).

The advantage of margin is that of leverage. If the price of stock increases you own more shares
than had you used only your own funds and your returns will be greater. The disadvantage of
margin is that if the price of the stock declines you will own more shares and your losses will be
greater than had you used only your own funds.