What is purchasing power?
Purchasing power, also called excess capital, is the money an investor has to buy securities when considering the term in a commercial context. Purchasing power is equal to the total cash held in the brokerage account plus all available margin.
Purchasing power explained
While purchasing power can take on a different meaning depending on the context or sector, in finance, purchasing power refers to the amount of money available for investors to buy securities in a leveraged account. This is called a margin account because traders take out a loan based on the amount of cash held in their brokerage account. Regulation T, established by the Federal Reserve Board (FRB), stipulates that the initial margin requirement of an investor in this type of account must be at least 50%, which means that the trader has twice the purchasing power.
Purchasing power of margin accounts
The amount of margin that a brokerage firm can offer to a particular client depends on the business and client risk parameters. Typically, margin accounts on stocks offer investors twice as much as cash held in the account, although some margin accounts of forex brokers offer purchasing power of up to 50: 1.
The more leverage a brokerage gives an investor, the more difficult it is to recover from a margin call. In other words, leverage gives the investor the opportunity to make increased gains by using more purchasing power, but it also increases the risk of having to cover the loan. For a borderless account or a cash account, the purchasing power is equal to the cash amount in the account. For example, if a borderless account has $ 10,000, it is the investor’s purchasing power.
Day Trading Purchase Accounts
Pattern day trading accounts work differently from regular margin accounts in that they require a minimum capital requirement of $ 25,000, compared to $ 2,000. While a trader must finance 50% of his shares in a standard margin account – which offers twice as much purchasing power, he or she only has to finance 25% of the cost of the securities purchased in an account day-pattern trading – giving the trader four times the purchasing power of stocks. For example, suppose Kate has $ 50,000 in her daily trading account; it could buy up to $ 200,000 in open trades during the trading day (50,000 x 4 = $ 200,000 in purchasing power).
Key points to remember
- Purchasing power is the money an investor has to buy securities.
- Purchasing power is equal to the total cash held in the brokerage account plus all available margin.
- A standard margin account offers twice the purchasing power.
- A day-pattern trading account offers four times more purchasing power.
- Additional purchasing power magnifies both profits and losses.
Real example of purchasing power
Suppose Gabe has $ 100,000 in his brokerage margin account and wants to buy shares in Apple Inc. (AAPL). Gabe’s initial margin requirement is 50% to enter into a transaction – some brokers may have an initial margin requirement greater than 50%.
To calculate Gabe’s total purchasing power, divide the cash amount in her brokerage account by the initial margin percentage. For example, divide the balance of $ 100,000 by 50%. As a result, Gabe can buy up to $ 200,000 in Apple shares. ($ 100,000 / 50% = $ 200,000). That said, the value of the margin account changes with the value of the securities held. The closer Gabe gets to the margin limits, the more likely he is to receive a margin call.