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The trading landscape has become more robust and complex in recent decades, introducing numerous new mechanisms and potential strategies to traders and investors. However, the trading field has also lowered its gates to newcomer enthusiasts. Digital exchange platforms, brokerage firms and online communities make it easy for newcomers to start trading in a matter of weeks.
Despite the digital assistance and simplification, numerous vital concepts are needed to master the trading field. Buying power is one of such crucial concepts, helping traders understand their leverage and trading capabilities without taking unnecessary risks.
- Buying power measures the trader's ability to purchase securities on the open market within a particular period.
In non-margin conditions, buying power equals the available cash reserves for the respective investors.
In margin trading, buying power represents the leveraged purchasing capabilities of the investor.
Increasing the buying power can amplify potential returns but also raise the risks of massive losses.
What is The Buying Power?
By definition, buying power is a trivial concept showcasing a given investor's trading scope. For example, if trader X can buy stocks or other securities with a total purchase price of $ 10,000 during the open hours, that sum represents their buying power. It is the total amount of potential purchases that trader X can carry out within a single period.
Thus, buying power represents a trader's potential ability to execute trading strategies on the open floor. Awareness of your buying power is essential to construct feasible trading tactics and grasp the full extent of your investment capabilities.
Buying Power In Margin Account Vs. Cash Account
As specified above, the buying power represents the potential purchasing scale for a specified trader in a single specified period, usually one day. In some cases, buying power is straightforward - it equals the investor's free cash deposits. However, the buying power concept becomes more fascinating with the margin trading niche.
So, let's start with the basics - what exactly is the margin trading practice? It refers to acquiring more buying power without having a corresponding free cash reserve as an investor. First, investors must set up a margin account and make an initial investment as collateral. Margin accounts are often available through a general brokerage account, making it easier for traders to open positions on their existing platform profiles.
Next, investors will undergo a vetting process, where they will be granted a leverage ratio that suits their current financial capabilities. Conservative leverage ratios are typically 2:1, meaning investors can purchase twice as many shares as their initial investment.
Thus, if investor X has deposited $50,000 as initial capital for their account, a 2:1 leverage ratio will allow them to open a position with a $100,000 valuation. Investors should also have enough cash reserves to satisfy the maintenance margin, which is the amount needed to be deposited while holding the position.
So, margin trading presents new and exciting opportunities for traders with limited funds. With this trading niche, the buying power no longer equals the immediate cash reserves available to traders, allowing them to devise more ambitious and large-scale trading strategies.
However, it is essential to note that the buying power in margin trading doesn't warrant ownership. Securities purchased by margin positions can yield returns for investors but do not represent the assets on the investor's portfolio. On the contrary, they represent a variation of borrowed funds from the brokerage firm, which has to be repaid in due time. Otherwise, a brokerage firm will inevitably seize the investor's entire portfolio on the respective brokerage account. While this trading practice is completely legal, the Securities and Exchange Commission (SEC) has stated that investors should be careful with this mechanism, as it is risky for inexperienced traders and borderline unethical in certain instances.
How Buying Power Defines Investing Decisions
As discussed above, the entire concept of margin trading was constructed to increase the buying power of potential investors. Thus, margin investing allows traders to purchase securities and stocks well beyond their financial capabilities. However, it is essential to note that buying power acquired by margin accounts comes with certain strings attached.
When a trader opens a margin account, they effectively borrow money from a brokerage firm. However, traders have to close their positions promptly instead of paying back the owed amount. If the stock acquired by margin positions manages to be profitable (or unprofitable in the case of short positions), traders will have no obligations to the brokers. However, if the position doesn't pan out, traders must compensate the broker's losses with maintenance margins.
If the losses exceed the maintenance amount and traders have insufficient reserves to account for them, they will experience a margin call and a subsequent stop loss order. If the latter occurs, the broker firm will seize all investors' assets to alleviate losses. Thus, the buying power presented by margin trading is a slippery slope, and it can turn into substantial losses in a short period. So, monitoring the margin levels and exiting the margin positions promptly is crucial before they endanger your entire trading portfolio on a given platform.
How to Calculate Buying Power When You Trade on Margin
The formula for identifying precise buying power is simple and depends on the leverage ratio in the margin account. If a given trader has leverage of 5-to-1, their buying power is five times the size of their margin deposits.
However, increasing leverage ratios proportionally decreases the safety blanket for traders as their margin call conditions become more stringent. Massive leverage increases risks associated with respective trading positions, meaning traders must be cautious with their strategies.
How Controlling Buying Power Helps You Avoid a Margin Call
As stated above, margin calls are warning statements issued by brokers, signalling that a particular margin position is close to being terminated. Avoiding margin calls is the prime directive for any margin traders, as it causes substantial portfolio losses. Realising the full extent of your buying power is a great way to control margin levels and sustain a healthy margin ratio during an open position.
Simply put, traders must always know how strong their buying power is and make margin trading decisions based on that number. For example, if investor X has a buying power of $ 200,000, executing strategies that don't use up the entire amount is wise, leaving room for tactical adjustments. Being aware of your leverage ratios is crucial, as they directly dictate the margin levels required to avoid the margin call.
There are several ways to increase the buying power to fulfil desired positions. The most popular way is to retrieve a margin loan from the broker. Margin loans are borrowings that utilise the investor portfolios as collateral. While they effectively provide additional financing, investors should carefully approach this option. Like the stop loss order, failing to repay these loans will lead to the brokerage firm seizing your collateral portfolio assets without exceptions.
Understanding the buying power concept is crucial in the trading landscape. With margin trading and similar practices, investors are no longer tied to their immediate cash reserves. While this new-found freedom is excellent news for traders with limited budgets, it is a double-edged sword. Increased buying power raises the stakes and invites significant risks into the equation.