Business & Finance Stocks-Mutual-Funds

What Is Margin Equity?

    Open Ended Losses

    • Many types of financial market deals involve an agreement now that will lead to an exchange of an unpredictable amount later on. This will mean that not only does a trader not know if a deal will be profitable or loss making, but he will not know how much he stands to lose. With simple trading, the maximum possible loss is the original purchase price. With more complex trading, such as with derivatives, the maximum possible loss can be much higher and potentially unlimited.

    Margin Concept

    • With large or unlimited potential losses, there is a double-edged form of risk: Each party has the trading risk that she will lose out on the deal, but each party also has the credit risk that the other will lose out but be unable to pay what she owes when the deal comes due for completion. In many such deals, the exchange itself acts as one of the two parties. To mitigate the credit risk, the exchange may insist on a margin payment, where the trader makes an up-front payment to the exchange to represent a portion of his potential losses. This money is returned at completion if the trader is the "winner" of the deal.

    Margin Trading

    • The idea of margin payments can also be used in traditional stock trading where traders simply buy and sell stocks with immediate payments. This occurs with margin trading, where a company lends a trader money to buy and sell stocks. The trader is required to put up a set percentage of this amount in cash.

    Margin Payments in Practice

    • The precise operation of margin payments depends on the type of transaction. Generally it works with the trader making an up-front payment. The trader is then required to make further payments if the market goes against him -- if market prices of the relevant asset mean it becomes more likely he will lose out or more likely he will lose out by a greater amount when the transaction is finally completed.

    Margin Equity vs Margin-Equity Ratio

    • Margin equity and margin-equity ratio have different meanings. Margin equity is simply the raw amount of cash a trader has deposited as margin payments. Margin-equity ratio is the proportion of the trader's available money that is deposited as a margin payment. Usually the higher the margin-equity ratio, the more risky the trader's overall strategy is.

Leave a reply