How Securities Are Traded

Chapter 3

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Types of Trades: Margin Trading
Why trade on margin?
Suppose a stock is currently trading at $10 a
share. Its price will be either $12 or $8
tomorrow. Calculate the return if you (1) use
your own money to buy one share, and
(2) borrow  $5 (borrowing
Own money rate = 0%) to $5
Borrow buy
one share.
Price goes up (12 – 10) / 10 = 20% (12 – 5 – 5) / 5 = 40%

Price goes down (8 – 10) / 10 = -20% (8 – 5 – 5) / 5 = -40%

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Types of Trades: Margin Trading
Example 1:
Nick is buying 200 shares at $40 a share
(ignore interest payment for now) with an
initial margin of 50%. The maintenance
margin is 30%. Calculate the price that
triggers a margin call.
Ans:
Loan = 0.50´200´40 = $4,000
Later on, it must always be that
Margin = (Account Value - Loan) /
Account Value > 30%
That is, (200P - 4,000) / (200P) ³ 0.3 BKM
Types of Trades: Margin Trading
Suppose one fine afternoon, not long afterwards, the price drops to $26.
How much will Nick have to put up when his broker calls (assume the
broker requires investors to bring the margin back to 50%)?
Value of account at lower share price
= $26´200 = $5,200
Maximum borrowing
= $0.50´5,200 = $2,600
Previous borrowing
= $4,000
Additional money required
= $(4,000-2,600)=$1,400
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Types of Trades: Margin Trading

If Nick cannot come up with the additional equity, he must liquidate

some of the account. Suppose he sells N shares at the lower price of
$26 and surrenders proceeds to the broker in order to bring his equity
back up to 50 percent. Calculate N.

Value of remaining position

= 26´(200-N) = 5,200-26N
His goal margin = 50%
(5,200 - 26N + 26N - 4,000) / (5200 - 26N) = 50%
N = 108 (we need a number > 107.69)

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Types of Trades: Margin Trading
•So  far we were bearish on the stock price. Now suppose that price
rises to $50. Confident that the winning streak will continue, Nick
decides to borrow more money to buy additional shares. How many
additional shares can he buy (margin requirement is still 50%)?
Value of his account
= 50 ´ ( 200 + N ) = 10,000 + 50N
Total borrowing
= 4,000 + 50N

0.5 =

N = 40 shares.
He owns 240 shares worth $12,000 and has borrowed $6,000.
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Types of Trades: Short Selling – Margin Call
Liability to the broker
= 100P
Value of the account
= $4,000 + $2,000 = $6,000
Nick’s equity in the account
= 6,000 - 100P
Margin = 30% = (6,000 - 100P) / (100P)
Solve the equation, we get P = $46.15

Expect a margin call when price rises above $46.15

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Example 4
Assume you sell short 100 shares of common stock at $30 per
share, with initial margin at 50%. What would be your rate of
return if you repurchase the stock at $35/share?

Ans:
Value of shorted stock = 100 ´ 30 = 3,000
My contribution = 3,000 ´ 50% = 1,500
Current stock value = 100 ´ 35 = 3,500
Return = (3,000 – 3,500) / 1,500 = -33.33%
(Compare: return for the no margin case = -5/30 = -16.67%)

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