Margin Trading enables an investor or trader to borrow money from the brokerage house to buy shares. Here the bought shares are kept as collateral with the brokerage company.
Margin trading allows the traders to trade on shares with limited money. There are two types of margin requirements needed to do the margin trading. One is initial margin requirement required to initiate the trading and second is maintenance margin requirement required to hold the trading.
Initial margin requirement denotes the initial percentage of money to be provided by the trader with the rest provided by the brokerage firm to initiate the trading. Maintenance margin requirement specifies the trader’s required equity position or value to continue holding the shares in the account. If the margin requirement is crossed the maintenance limit, the trader has to deposit more money or sell some shares to bring the account back to its maintenance margin requirement.
Mathematically when the maintenance margin is used completely,
Profit of the trader at market price x = Maintenance margin
Or, (X-6) = X (0.25)
Or, X (1-0.25) = 12(1-0.5)
Or, X (1 – Maintenance margin) = 12 (1 – Initial Margin)
Or, X = 12 (1 – Initial Margin) / (1 – Maintenance margin)
Or, X = USD 8
Margin Trading increase the profit and rate of return as lower initial amount is used to do the trading. At the same time it increases risk as well because of higher exposure with the same amount of money.
If the share price increases by 25% to USD 15 then the profit will be (15-12) = USD 3 per share or USD 3000 as a whole. In this case the rate of return will be (3000/6000)*100% = 50% when the share price itself was increased by only 25%. This is how it increases the profit.