The Power Of Margin Trading

Margin trading or sometimes known as share financing refer to borrowing money from the brokers or banks to buy shares. To protect themselves, the lender will typically lend only 70% of the value of the shares and the borrower will have to put in the remaining 30%.

Margin trading is a very popular financial product as it offers several benefits such as:

1. Increasing your buying power – you can buy 3x more shares
Without Financing With Financing
Cash Outlay $30,000 $30,000
Margin Loan $0 $70,000
Shares Purchased $30,000 $100,000
2. Leveraging your returns – 20% increase in stock price give you almost 60% in return
Without Financing With Financing
Cash Outlay $30,000 $30,000
Shares Purchased $30,000 $100,000
Scenario: Share price increase by 20% after 1 year
Proceeds from Share Sale (exclude transaction cost) $36,000 $120,000
Interest on Margin @3% 0 $2,100
Net gain $6,000 $17,900
Return on investment 20% 59.7%

 

3. Carry trades – Buying shares with dividends higher than interest on margin loan
Without Financing With Financing
Cash Outlay $30,000 $30,000
Shares Purchased $30,000 $100,000
Scenario: REITs with 6% Dividend
Dividend Income $1,800 $6,000
Interest on Margin @3% 0 $2,100
Net gain $1,800 $3,900
Return on investment 6% 13%

 

4. Diversification of Portfolio

For those with small amount of cash available for investment, it will be difficult to built a diversified portfolio of shares unless you buy exchange traded funds (ETFs). With the use of margin financing, the investor will be more capable of diversifying its portfolio. 

The benefits for using margin although attractive, comes with certain risks too. First up, while your returns can be leveraged up, it can amplify your losses as well. Based on the example below, a 10% drop in share price will return a -40.3% in your returns.

Without Financing With Financing
Cash Outlay $30,000 $30,000
Shares Purchased $30,000 $100,000
Scenario: Share price decrease by 10% after 1 year
Proceeds from Share Sale (exclude transaction cost) $27,000 $90,000
Interest on Margin @3% 0 $2,100
Net loss -$3,000 -$12,100
Return on investment -10% -40.3%

Secondly, there is a requirement to maintain the margin ratio.

Margin Ratio = Value of the shares / Value of the loan

Most lenders will require the borrower maintain the margin ratio above 135%. If the margin ratio drops below 135%, a “margin call” will be triggered and borrower will have to top-up cash to reinstate the margin ratio.

Initial Share Price Drop by 6%
Cash Outlay $30,000 $30,000
Margin Loan $70,000 $70,000
Value of Shares $100,000 $94,000
Margin Ratio 143% 134%
Cash Required for Margin Call n.a. $4,000

In the event that you are unable to top-up the cash required or if the margin drops below 130%, the lender can force sell your position.

Thirdly, there is the interest rates risk which is especially critical during this period where interest rates is rising. Yes, like your home loan, the interest rate is not fixed and can be increased anytime. However, on the Juggar platform, interest rate is fixed for the tenure of the loan, giving borrower the added certainty. 

In summary, margin trading is a double-edged sword. It can boost your returns but also make your wrong bets even more painful. However, if you have a clear investment strategy and do your homework, margin trading is a powerful tool to help you attain your financial goal faster.   

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