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The entry barrier to financial markets is lower than ever, with more traders and participants joining and capitalizing on opportunities to make money. Trading is no longer exclusive to financial entrepreneurs and experts who reside in stock exchange marketplaces and operate from trading floors. Today, almost anyone can start trading.
The learning curve is now shorter, and one can benefit from the various learning materials found online and at brokerage firms. However, this does not eliminate the need for basic market understanding, such as market dynamics and buying power.
In this article, we will explain the buying power concept and its impact on margin trading.
Understanding Buying Power
The buying power refers to the trader’s potential investment in how many market orders they can execute. For example, if an investor, John, has $10,000 in their trading balance that he is willing to spend to buy stocks, currency pairs or other securities. Thus, the buying power is represented by the number of possible trades John can execute within a given time.
The trader’s buying power determines the capacity of trading, which defines the investment strategy in various financial markets. This concept helps the investor craft their trading style and objectives.
Margin Accounts Vs. Cash Accounts
Buying power can simplified by the amount of money the trader has in their account, which they can use in one day, for example. However, this concept is easier to understand with cash accounts, while margin accounts slightly change this concept.
The Margin trading account implies trading with the broker’s money, which alters this concept a little bit compared to cash accounts. Let’s discuss the difference between margin and cash accounts.
Explaining Margin Accounts
Margin accounts increase the trader’s buying power by allowing them to place market orders using the broker’s money. Thus, a trader may not be able to afford a specific market position with their money and use leverage to amplify their capabilities.
Traders use leverage to explore high-value trading opportunities to amplify their gains at amplified risks. Brokerage firms offer margin accounts after a screening process that evaluates the investor’s capital and capacity.
Then, an investor opens the margin account and makes the first deposit. The broker may use the first deposit amount as collateral to process the leverage trading position and assign a leverage ratio based on the trader’s capital after the KYC procedure.
For example, if John has $1,000 in his account and his broker offers him 1:10 leverage, it means that John can multiply his buying power tenfold and place market orders up to $10,000 using the broker’s borrowed funds.
Margin accounts entail several considerations like initial margin and maintenance margin, which is the amount of money the trader must keep in their account to hold the leveraged position.
However, using leverage is risky and can put the trader at significant risk if the market moves sideways. Exploring high-value market positions can bring substantial returns, but financial markets are volatile, and a trader may lose the position and become indebted to the broker.
Explaining Cash Accounts
On the other side of the spectrum, we have cash accounts, which are more straightforward and easier to use. Trading with a cash account means that a trader can place market orders only using money available in equity.
Using leverage is not possible with a cash account, and a trader can only sell securities they own. Margin trading allows investors to sell stocks and other securities without owning them, which can be done by borrowing these stocks from the broker.
However, shorting (selling) stocks in cash accounts can only be done if the trader owns the underlying stocks in their account.
How Does Buying Power Affect Trading Strategies?
The Buying power can dramatically change using margin accounts because the leverage can multiply the trader’s capacity and increase the number of trades they can execute within a given period of time.
Margin accounts equip trades with a higher buying power, where they can buy stocks, trade currency pairs, or purchase cryptocurrencies that they cannot originally afford thanks to the broker’s borrowed funds.
A trader can use leverage to capitalize on market opportunities or speculate on upcoming market trends. For example, if a company is launching a new product or a market phenomenon is occurring. Thus, leverage can multiply the investor’s gains to pay the broker back and still make remarkable profits.
Leveraged trades must be closely monitored and close these positions as soon as the trader reaches their objective or target price. It is recommended that an investor set their expectations and targets before they execute a leveraged position and quickly close the position once they attain the targeted price level.
Keeping the margin trading position open for a long period of time may expose the trader to upcoming market volatility and price fluctuations that diminish any gains made from the leverage.
Therefore, while creating the price expectations and strategy, it is important to set a stop loss order to avoid going negatively if the market moves in an undesirable direction. If the market position moves against your favor and reaches a certain level, the broker may produce a margin call, asking you to add more funds to the maintenance requirement.
Calculating The Buying Power
In cash accounts, the buying power is represented by the amount of money the investor has in their account and how much they can purchase using this money.
On the other hand, the buying power in margin accounts is represented in the leverage ratio. For example, if the broker offers a 1:10 ratio, then the trader’s buying power multiplies the cash amount by 10.
Buying power is an essential trading concept that refers to the investor’s ability to execute market orders with the money available in trading accounts and within a given timeframe.
The buying power can be as straightforward as the available cash in the trader’s equity. However, with margin accounts, this concept changes slightly because the leverage amplifies the trader’s capability and increases the potential market orders they can place in a specific time period.