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Homework answers / question archive / As an investor in the financial market, you have two situations that you can make a profit out of
As an investor in the financial market, you have two situations that you can make a profit out of. Currently, the stock price is $30 per share. Identify the best strategy to follow for each case. Draw the balance sheet for both cases before and after you take a position (Assume 100 shares for each case) First: When you expect that the price of BETA will increase in 30 days to $40. The broker's initial margin requirement is 60% of the value of the position. The maintenance margin is 20%. What will be your strategy and your position? How much will you lose or gain if you closed your position after 30 days? Do you receive a call if the price will be $15 per share? What should be the price of the stock for you to receive a margin call?
Current Stock Price = $30
No. of Shares = 100
Expected Price after 30 days = $40
Initial Margin Requirement = 60%
Maintainence Margin = 20%
(a)
The strategy would be to do margin trading i.e. buy more shares than our funds. It means that we put in some money and borrow the additional money from the broker and take the requisite position. When we exit our position, we would pay back the loan of the broker first and then balance would be our payoff.
This way we can multiply our position which means gains or losses would be multiplied in this case. Thus, if we are confident of our call, then it is a better position as our gains would be multiplied. Broker would benefit in this case, as if we are taking more position, it would mean more brokerage for him. Also, this facility is offered to only credit worthy individuals and involves interest on the loan.
Since, we are betting that in next 30 days, stock would rise to $40, we should go long for the 100 shares at current share price.
Initial Money required for strategy = Current Share Price * Quantity * Initial Margin Requirement
Initial Money required for strategy = 30 * 100 * 60% = $1,800
Thus, we require only $1800 for this strategy but we are taking larger position than $1800.
Borrowed Amount = Current Share Price * Quantity - Initial Money Required
Borrowed Amount = 30 * 100 - 1800 = $1,200
In essence we are borrowing $1200 from the broker to fund our purchase.
(b)
If after 30 days, our expectations come true and we close out our position, then
Value of Portfolio = Expected Price * Quantity - Borrowed Amount
Value of Portfolio = 40 * 100 - 1200 = $2,800
Thus, value of our portfolio would be $2,800 after 40 days.
Gain = Value of Portfolio - Initial Investment Required
Gain = 2800 - 1800 = $1,000
Gain on our position would be $1000 after 30 days.
Gain in % = Gain / Initial Investment Required
Gain in % = 1000 / 1800 = 55.56%
Gain would be 55.56% of the initial investment.
(c)
If Share Price after purchase = $15
Value of Investment = Share Price after purchase * Quantity
Value of Investment = 15 * 100 = $1500
Maintainence Margin Required = Value of Investment * Maintainence Matgin Required
Maintainence Margin Required = 1500 * 20% = $300
Margin A/C Balance = Initial Margin Required - (Share Price after purchase - Share Price today) * Quantity
Margin A/C Balance = 1800 - (15 - 30) * 100 = $300
Since the margin A/C balance is equal to maintainence margin, there won't be any margin call.
(d)
As we can see from part (c) that $15 is the minimum point when margin call will not be made. In case the price slide further there would be a margin call. So, the price should be just below $15 to trigger the margin call.
