There are many different ways in dealing in the stock market, derivatives such as CFDs, Options and Futures or buying the real thing directly, which can be done in 2 different ways.
One can buy actual shares of any stock and pay 100% of their value, this is the simplest way of dealing in the stock market and it means that the investor can keep these shares indefinitely long. On the other hand however it is also possible to trade stocks on margin, and this allows the investor to borrow up to 50% of the funds required, from the stock broker. This is known as margin trading and it’s like getting a loan to finance the investment with, there are however some details. Margin trading is good for short term trading and investing, interest is charged on your account on a daily basis, it can however be much more affordable than buying the actual stock outright.
For example: An investor wants to buy stocks of a given company, the stock is priced at $100 per share, and he wants to buy 1000 shares of this stock in anticipation it will make a move from $100 to $120 over few months. However he only can afford $50,000 worth of this stock. So he goes to a margin trading stock broker, and he finds out that he can indeed trade this stock on margin, with only $50,000 capital.
If the stock does make it to $120 over the next 3 months, the investor will have a stock investment now worth $120,000 less the interest charges. Based on a 3 month period, and an actual lending rate of 7%, then this investor will be charged $841 for interest. His investment will be worth $120,000 and so before dealing costs which are not significant, his actual net profit will be: ($120,000 – $50,000 -$50,000 – $841) = $19,159. Which seems like a very good return on his original $50,000 investment.
More specifically, imagine another investor who also bought the same stock for the same period of time, but he bought them on full value:
Investor buying the stock on full value: Paid $100,000, got back $120,000, total return = 20%
Investor buying the stock on margin: Paid $50,000, got back $69,159, total return = 38.3%
As you can see the margin investor achieved almost double a return using the leverage margin stock trading offers.
It’s important to realize that if you go short a stock traded on margin, then the meaning of the interest charge reverses, and the broker has to pay you that interest by crediting it into your account. Different margin brokers have different interest rate policies and these can vary enormously from broker to broker.
Note that not all stocks are offered for margin trading, only quality stocks with intrinsic value that are seen as collateral by the broker can be offered for margin trading.
