Margin Trading Accounts – Investors Buying on the Margin to Amp Up Gains

Margin trading accounts are employed by savvy investors to turn small allocations of capital into enormous profits by using leverage to turn a small amount of purchasing power right into a substantially larger purchase. There are a number of ways this sort of account is used, but don’t let the examples here close your mind to other styles of trades using margin trading accounts.

The most common type of trade using margin trading accounts is the straight options purchase. Although a traditionalist wouldn’t normally technically call this a margin trade, most brokers require at least minimum security margin trading accounts so that you can trade options. Likewise traders sign the same trade account agreement therefore i say it’s the same (enough) for me. A normal option trade happens when an investor purchases the right to get (a call) or to sell (a put) shares of common stock of a company at a specified price (the strike price) on or before (American options) a specified date.
How does this create increased purchasing power for the investor? Think about the following example:
Albert and Bill each have $10000 to get. Albert decides to buy shares of hypothetical company JCN at $100 per share. As of this price he can buy all of 100 shares, and once he does, Albert has control of $10000 worth of JCN stock.
Bill alternatively is aware of margin trading accounts and wants to buy call options of JCN stock rather than buying the stock itself. For simplicity’s sake suppose Bill can buy calls on JCN for $1 per share. Bill uses his $10000 to get 100 contracts (a contract is for 100 shares) – so Bill now holds the right to buy 10,000 shares of JCN.
Bill will not own any shares of JCN currently, however he controls an impressive $1 million worth of JCN because he holds the right to buy 10000 shares (which currently price of $100/share are worth $1million).
By taking benefit of his understanding of margin trading accounts, Bill has created what amounts to a 100:1 leverage position in accordance with Albert’s securities holdings. What will happen if JCN stock jumps to $102/share (a 2% price swing is a very possible scenario in the current markets)?
Albert’s 100 shares now trade at $102/share, making Albert’s investment worth $10200.
Bill’s 100 contracts should now be worth about $2/share (option pricing isn’t a precise science), making Bill’s holdings worth $20000, doubling his money.

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