4) Margin Trading: The Advantages

It is normal for companies to borrow money to finance projects. Similarly, investors can borrow money to boost their buying power. It is like doubling the funds in an account. Margin can dramatically increase profit because of the leverage it gives to an investor.

Think of it this way: An increase in initial margin up to 50% will afford you twice as much stock as you normally could with just the cash in your account. Margin allows you the chance to increase your returns compared to trading purely from a cash position.

To illustrate how leverage can increase your profit, let us show an example. For the sake of this example on the power of leverage, we will leave out commissions and interest which are costs that are part of margin trading.

John has $15,000 in his margin account. This gives him a buying power of up to $30,000 – $15,000 in cash and $15,000 in margin. Company X is trading their stock at $100 and there are indicators that it will rise soon. If John was buying without margin, he would only be able to buy 150 shares ( $15,000/100 = 150). However, with the margin, John now can buy twice as much shares ( $30,000/100 = 300).

Company X then pulls off a crazy marketing stunt with positive feedback and the price of their shares jumps up 30%. Because of the increase in the price, John’s investment is now worth $39,000 (300 x 130). He decides to cash out afterwards. Paying back the broker the $15,000 on loan, John keeps $24,000, $9,000 of which is profit. The return is over 60% of his investment because he was able to buy more stocks from the margin.