Investors who trade securities through an online brokerage account or margin account may see references to buying power or excess equity when reviewing the amount of money they have available to purchase securities. So what is buying power in stocks, exactly?
In simple terms, it determines an investor’s ability to make trades at any given time. Understanding the differences in what it means to have more or less power to buy stocks, options or crypto can help with shaping investment decisions.
What Is Stock Buying Power?
Buying power, or excess equity, is a measure of how much capital an investor has available to trade stocks, options, cryptocurrency, and other securities.
There are different ways to measure buying power, depending on the type of account an investor has. Completing trades can reduce an investor’s ready capital while selling securities and depositing the cash into their trading account can increase it.
There’s no standard buying power definition; instead, it’s simply a way to gauge an investor’s ability to trade, based on the financial resources they have in their trading account.
Buying Power vs. Purchasing Power
This is not the same thing as purchasing power, however. Purchasing power refers to the amount of goods or services a given unit of currency can purchase, when factoring in inflation. Often purchasing power comes up during discussions of how inflation may affect a portfolio’s returns.
Recommended: How to Invest During Inflation
How Does Buying Power Work?
To understand how buying power works, it helps to understand when this term comes into play. The types of accounts that use or reference buying power include:
• Margin trading accounts
• Cash brokerage accounts
• Individual Retirement Accounts (IRAs)
Margin trading involves using leverage, or borrowing cash, from a broker-dealer to purchase securities using the assets in a brokerage account as leverage or collateral. Trading on margin can increase an investor’s buying power above what they’d have in a cash account or IRA. (Cash accounts and IRAs don’t use margin or leverage.) While trading on margin can enhance risk, it can also double the amount of capital an investor has available to make trades with.
Recommended: What is a Brokerage Account?
Pattern day trading can also increase buying power for margin investors who prefer active trading versus a buy-and-hold approach. The Financial Industry Regulatory Authority (FINRA) defines a pattern day trader as any investor who executes four or more day trades within five business days, provided that the number of day trades represents more than 6% of the investor’s total trades in the margin account for that same five-day period.
How to Calculate Buying Power?
The method of calculating buying power depends on the kind of account involved. With a brokerage account or IRA, this calculation is simple. An investor would simply add up the amount of cash they have available to trade. So if someone has $20,000 in cash in their brokerage account they’d have $20,000 in buying power.
With margin accounts, buying power is typically double the amount of equity they have in their accounts. So an investor who has $25,000 in a margin account would have $50,000 of stock buying power in that instance.
With pattern day trading, the buying power is four times the amount of equity. So if an investor has $50,000 in cash or equity with which to trade, they could have up to $200,000 in buying power using pattern day trading rules. It’s important to note that if an investor exceeds their day trading margin limits, their brokerage may issue a margin call.
A margin call can happen if the value of securities in a margin account drops below a set level, as determined by the brokerage. When that occurs, the investor may need to deposit cash or other securities in their account or sell securities to make up a shortfall. The more leverage a brokerage allows, the more difficult it can be for an investor to fill the gap when there’s a margin call.
Recommended: What Is a Margin Call?
Buying Power Example
Assume that an investor has $10,000 in cash in a margin account. They want to use that $10,000 to purchase shares of stock. The stock has a 50% initial margin requirement.
The investor’s buying power calculation looks like this:
$10,000 in cash divided by 50% initial margin requirement = $20,000 in margin buying power
Now, assume that same investor has $100,000 in cash instead to purchase stocks with. Using the same initial margin requirement, the calculation looks like this:
$100,000 in cash divided by 50% initial margin requirement = $200,000 in margin buying power
It’s important to remember that the value of the stocks the investor owns can determine the value of their margin account. When the value of the account increases, that can lead to more gains for the investor but it can also increase their odds of a margin call.
How to Use Buying Power
If you’re interested in trading stocks, options or crypto investing, having more buying power can work in your favor. Trading on margin can allow you to invest larger amounts of money and it has the potential to magnify your investment returns.
Say you have only $5,000 to invest. You open a margin account and your brokerage allows an additional $5,000 in buying power for a combined total of $10,000. You use this $10,000 to purchase 500 shares of stock which are trading at $20 each.
The stock’s price doubles to $40 per share. Now your shares are worth $20,000. You decide to sell, paying back the $5,000 margin loan to your broker. You also pay $500 in interest for the loan. That leaves you with $14,500 in profit.
Now, say you used $5,000 to buy 250 shares of that same stock. Once the stock’s price doubles to $40, you sell them and rake in a $10,000 profit. You’re still coming out ahead but trading on margin would have given you more buying power and thus more profits.
When using buying power to your advantage, you do have to consider the risks as well. Just as margin trading can increase your profits, it can also increase losses if the securities you purchase decline in value. In the event of a margin call, you’d have to liquidate some of your holdings or deposit extra cash to cover the difference.
Understanding how buying power works matters, especially if you’re a day trader or you’re trading on margin. And even if you’re a beginning investor, it’s still important to know what this means when it comes to your first brokerage account or IRA.
If you’re interested in trading stocks online and making the most of your buying power, you can get started on the SoFi Invest® brokerage platform. While the platform does not allow you to trade on margin, you can build a portfolio composed of stocks, exchange-traded funds and cryptocurrency.
Photo credit: iStock/solidcolours
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