What is Open Trade Equity?

Last Updated July 28th 2021
6 Min Read

Investing in shares, stocks and other securities is a way to gain profit… or lose money. If you are an investor who trades quite often, you are most likely to have gone through losses and gains. Sometimes the loss is immediate, sometimes it is more gradual. In other cases, your losses could be missed profits or at times opportunity losses.

Gains and losses can be divided into two categories – realized and unrealized. Gains or losses are said to be realized when a gain or loss is recognised and is listed on the income statement. When assets are sold for a price lower than the original purchase price it is called a realized loss. Similarly, selling an asset at a price higher than the original purchase price is known as a realized gain.

On the other hand, unrealized profit or losses are the profits or losses that have only happened on paper, where transactions have not taken place.

For instance, a company owns a share worth $8,000. If the share value increases to $10,000, though the company makes a paper profit of $2,000, this is not recorded as income. The unrealized profit is marked in the owners’ equity section of the balance sheet.

Tax Implications of Unrealized Gains and Losses  

As per the Income Tax Act, 1961, all profits that are made through the sale and subsequent transfer of stocks and other securities are capital gains and are accountable to be taxed accordingly. Similarly, any losses that are made through the sale and subsequent transfer of stocks and other securities are labelled as capital losses.

You can use your capital losses to reduce your tax burden by either offsetting your capital gains or by carrying it forward to the future capital gains. On top of that, even if you don't have capital gains, you can use your capital loss to offset ordinary income up to the allowed amount. 

However, unrealized gains and losses are only potential profits and losses and no sale and subsequent transfer of the said asset has been made. For the same reason, from a tax perspective, regardless of how large the unrealized gains and losses are, there are absolutely no tax implications whatsoever. To reduce your tax burden, there are strategies like adopting a staggered selling approach to keep your profits unrealized.

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Open Trade Equity

The net of these paper gains and losses also known as unrealized gain or loss, respectively, represented by the current market value and the price paid/price received for a position is known as open trade equity.

An unrealized gain in an open position is technically known as open trade equity. If the share prices dip instead of rising, it would have eroded the capital invested. This unrealized loss is, therefore, a negative open trade equity. While the concept of open trade equity is standard, it could be categorised separately in the case of a profit or a loss. A paper profit is termed as positive open trade equity and a paper loss is called a negative open trade equity. 

To understand the concept of open trade equity in practice, here is a live example we can look at.

An Example of Open Trade Equity 

Mr A is a trader who is tracking a particular stock, XYZ Corp, and is looking to buy it. His research and the market buzz tell him that there is a strong likelihood that the price can appreciate from its current levels of $50 per share to $75 per share. He decides to buy 100 shares in all and places an order at $50 per share. 

At this point, Mr A’s holding of XYZ Corp is worth $5000. He holds on to it for a month’s time, which is the expected duration for the stock to appreciate to the $75 per share levels. 

As per the estimate, XYZ Corp’s share price steadily increases and in just over a month touches the $100 levels. At this point, Mr A sells off his entire holding of 100 shares for an overall consideration of $7500. This has fetched him a profit of $2500. 

But, during this period when he still held on to these shares, there has been an appreciation that also was happening. If, in 15 days, the price of XYZ Corp rises to $60 per share, the holding value of Mr A’s portfolio at that point would have risen from $5000 to $6000. This led to a notional gain of $1000 which can be deemed as a paper profit too. 

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Open Trade Equity in Margin Accounts

Now, if an investor plans to avail of the margin facility in trading, how does the concept of open trade equity work here? 

Here is an example of how the Open Trade Equity works in margin accounts.

Mr B is looking to buy shares of PQR Corp that he has been tracking for a while and expects to do well at the stock market. The stock is trading at $60 per share and he is planning to buy 200 shares. He would need additional funds to manage the investment of $12,000. For this, he opens a $6000 margin account with a broker who offers a 50% initial margin. There is also a 35% maintenance margin requirement with this account which amounts to $4200. 

Mr B places an order for 200 shares of PQR Corp for $12,000 using up $6000 of his own funds and another $6000 (being the 50% margin) from the amount borrowed from the broker. The maintenance margin continues to be $4200 and will be used as and when required. 

As for the open trade equity, it will be set at zero upon purchase of the stock. But then, there is an unexpected drop in the share price and PQR Corp starts trading at $30 per share. This brings down the portfolio value to $6000, leading to a negative OTE of $6000. As a result of the 50% initial margin requirement, Mr B’s deposit has eroded from $6000 to $3000. This is when the maintenance margin will get invoked and a margin call will be made. 

Mr B will now also have to infuse fresh funds to make up for the gap between the 50% margin requirement and the balance he now has in the account. In his case, this will be $6000 (the required amount) minus $3000 (the current balance) amounting to $3000. To square up this shortfall, Mr B can either deposit cash or any securities that are marginal. The other option is to reduce the margin requirement by selling off the shares at a loss to close or reduce his open position. 

Any investor opening a margin account needs to have a minimum of $2000 in cash or securities. This is as mandated by the Financial Industry Regulatory Authority (FINRA) who requires a maintenance margin of a minimum of 25%, up to 30%, by an investor. This means that anyone opening a margin account needs to necessarily maintain at all times a balance of at least 25% of the market value of the securities in the portfolio

If an investor cannot or does not want to deposit cash or sell holdings at the time of a margin call, their brokerage is authorized to close open positions at their discretion and maintain the account to its minimum value.

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