Buying Power And Margin Trading: How Do They Influence Each Other

The trading landscape has evolved significantly in recent decades. The trading field offers numerous new methods and techniques for established traders and is becoming more welcoming for newcomers, thanks to internet groups, brokerage agencies, and digital exchange platforms.

Despite the rise in digital tools and accessibility, mastering essential trading concepts like buying power is crucial for traders to effectively manage leverage and trading capacity without taking unnecessary risks.

What Is Buying Power?

Buying power is a crucial metric indicating an investor’s trading potential, which means the total number of possible purchases during open hours. For example, Trader X can spend $10,000 on stocks or other assets during open hours, representing Trader X’s total purchasing capacity.

Understanding a trader’s buying power is vital for developing effective trading strategies and maximizing the full potential of their investing resources on the open floor.

Margin Accounts vs Cash Accounts

Buying power refers to the maximum amount a trader can acquire within a given time frame, often one day. It can be as simple as free cash deposits, but margin trading adds more interest to this concept.

Margin trading is a strategy that increases buying power without having enough spare cash for investment. It involves opening a margin account and funding it with initial collateral. Most brokerage accounts offer margin accounts, making it easier for traders to initiate trades on their platform profiles.

Investors are often assigned a conservative leverage ratio of 2:1, allowing them to buy twice as many shares as they initially invested.

Margin Trading: A Quick Example

Let’s look at the example. Investor X can execute a $100,000 trade with $50,000 initial money and a 2:1 leverage ratio, provided they have enough cash to cover the maintenance margin, that is, the amount invested to maintain the position.

Margin trading offers low-budget traders exciting options for achieving their goals, enabling them to develop ambitious and extensive trading strategies when their buying power doesn’t match their immediate cash reserves.

Margin trading does not equal ownership, as the securities bought on margin do not constitute the portfolio’s assets but are borrowed money from the brokerage company, which must be paid back on a pre-set schedule.

If an investor’s entire portfolio in a brokerage account is not secured, it could be seized by a brokerage business. The Securities and Exchange Commission (SEC) advises caution in this scenario, as it may be risky for novice traders and potentially unethical.

Advantages Of Margin Trading

Margin trading offers several advantages, including greater purchasing power, magnified profits, and flexibility. You can own more shares with leverage than cash accounts, magnifying your potential profits. 

Due to the increased leverage provided by the larger value of the assets used as collateral, margin trading also offers additional opportunities for purchasing on margin. As long as you fulfil the broker’s maintenance margin criteria, you only have to return the loan when the stock is sold, unlike other loans with set payback schedules.

However, margin trading is not free, and you must pay interest on borrowed money from your broker. Margin interest rates range from 4.75% to 12%, and you owe interest regardless of your investments’ performance. 

You can receive a margin call and be required to make further deposits if the value of the securities in your margin account drops too much and your account equity is less than the required minimum maintenance. The broker could liquidate the stocks you bought on margin if you don’t deposit enough money by the deadline, which might result in large losses.

How To Avoid Margin Calls

A margin account allows you to purchase securities using your own money and borrowed money from the broker. This allows you to trade more than you would be able to without the borrowed money and increase your returns. 

However, a maintenance margin requirement demands you to maintain a certain percentage of equity in your account. If your portfolio falls below the maintenance margin, you may get a margin call from your broker. 

Once you’ve received a margin call, you can deposit additional cash or securities to your account or sell securities at depressed prices to make up the shortfall. If you cannot meet the margin call quickly, your broker may sell securities without your permission. 

Margin calls occur during periods of high market volatility when a security’s value falls below the required maintenance margin. 

To increase buying power, investors can use margin loans, which are credit advances used as security in investors’ portfolios. However, caution is advised as these loans can be likened to a stop loss order, as if not repaid, the brokerage company will take complete custody of the assets in the collateral portfolio.

The Influence Of Buying Power On Trading Strategies

Margin trading aims to increase buying power for potential investors, enabling them to buy stocks and assets beyond their means. However, it is important to consider that the purchasing power obtained through a margin account is subject to specific conditions.

A trader creates a margin account, borrowing money from a brokerage business. They must close their positions quickly without making outstanding payments. Trades are not mandatory for brokers if the shares acquired through margin positions are profitable or, conversely, unprofitable in the case of short positions. The trader must use a maintenance margin to cover the broker’s losses if the position fails.

Margin trading is a risky strategy where traders face margin calls and stop loss orders if their losses exceed the maintenance amount and the traders lack sufficient reserves. Brokers may seize all investors’ assets to cut losses, making the buying power of margin trading an unstable asset. Monitoring leverage levels and closing margin positions promptly is crucial to avoid significant losses on a specific platform.

How To Calculate Buying Power

A trader’s buying power is determined by their margin account’s leverage ratio, which is calculated as five times the amount of their margin deposits.

As margin call requirements tighten, rising leverage ratios decrease traders’ safety net and increase risk, necessitating caution in developing trading strategies.

Final Takeaways

Understanding buying power is crucial in trading, as margin trading allows investors to release their immediate financial reserves. While this independence is beneficial for tight-budget traders, it also introduces risks and puts more at stake.