What is Buying on Margin?
Buying on margin is an operation where a buyer borrows certain amount of money from his broker to complete a investment transaction. It is a loan extended by the broker to finance the operation.
Buying on margin occurs when an investor buys an asset by borrowing the balance from a bank or broker. Buying on margin refers to the initial payment made to the broker for the asset—for example, 10% down and 90% financed. The investor uses the marginable securities in their broker account as collateral.
The buying power an investor has in their brokerage account reflects the total dollar amount of purchases they can make with any margin capacity. Short sellers of stock use margin to trade shares.
What Does Buying on Margin Mean?
In order to buy on margin a person must hold a margin account with his broker. These accounts have different conditions and operational characteristics than regular accounts. When a person buys certain security on margin it means that the broker finances a part of the transaction. The account holder places a down payment, which means a portion of the total amount invested and the broker pays for the rest. The securities being bought are held as collateral for the loan and there are elements like maintenance margins, minimum margins, interest expenses and operational expenses that are also charged to the holder to sustain the margin account.
As any other loan, the financial institution will assess the person’s or institution’s creditworthiness before the margin account is actually approved. Also, there are certain procedures such as “margin calls” that can be employed if the margin account balance is reduced by adverse results. These calls are measures that allow the broker to liquidate investment positions in order to maintain the minimum equity portion required for the margin account.
How Does Buying on Margin Work?
You want to buy 1,000 shares of Company XYZ for $5 per share but don’t have the necessary $5,000 — you only have $2,500. If you buy the shares on margin, you essentially borrow the other half of the money from the brokerage firm and collateralize the loan with the Company XYZ shares. This original loan amount as a percentage of the investment amount is called the initial margin.
If the value of the Company XYZ shares drops past a certain point, say 25% of the original $5,000 value (or $1.25 per share; this point is called the maintenance margin), the brokerage firm may make a margin call, meaning that within a few days you must deposit more cash or sell some of the shares to offset all or part of the difference between the actual stock price and the maintenance margin. The broker does this because it has lent you $2,500 and wants to mitigate the risk of you defaulting on the loan. Federal Reserve regulations and the broker’s internal policies determine the initial margin and maintenance minimum percentages.
Getting a margin call means that not only do you have to pay back the original $2,500 of principal eventually, but you have to pay the margin call. However, if the stock rises from $5 to, say, $15, you’ve just made $10,000 without investing all of your own money.
Margin accounts must follow a margin agreement, which the investor must sign, as well as regulations imposed by FINRA, the Federal Reserve, and even the New York Stock Exchange.
Risks of buying on margin
Buying on margin has a checkered past. “During the 1929 crash, there was very little regulation of margin accounts, and that was a contributor to the crash that started the Great Depression,” says Victor Ricciardi, visiting assistant professor of finance at Washington & Lee University.
Can lose more than your initial investment
The biggest risk from buying on margin is that you can lose much more money than you initially invested. A loss of 50 percent or more from stocks that were half-funded using borrowed funds, equates to a loss of 100 percent or more, plus interest and commissions.
For example, let’s say you buy 2,000 shares of XYZ company with $10,000 of your own cash plus $10,000 in your margin account at a cost of $10 a share. That’s a total of $20,000, excluding commissions. The next week, the company reports disappointing earnings and the stock drops 50 percent. In that scenario, you lose all of your own money, plus interest and commissions.
Could face a margin call
In addition, the equity in your account has to maintain a certain value, called the maintenance margin. If an account loses too much money due to underperforming investments, the broker will issue a margin call, demanding that you deposit more funds or sell off some or all of the holdings in your account to pay down the margin loan.
“If markets or your overall positions decline, your broker can liquidate your account without your approval. That’s an important downside risk,” says Ricciardi.
Even those who advocate buying on margin in some situations despite the risk warn that it can amplify losses and requires earning a return that exceeds the margin loan rate.
“Margin trading is for experts who understand the mechanics of it — not your average retiree,” says Ricciardi.
Benefits of buying on margin
Of course, if an investment purchased on margin does well, the gains can be richly rewarding.
Besides using a margin loan to buy more stock than investors have cash for in a brokerage account, there are other advantages. For instance, margin accounts offer faster and easier liquidity.
“For most of our clients, we like to have a margin account even if they never buy stocks on margin because they can transfer money faster,” says Tom Watts, chairman of Watts Capital Partners, a broker-dealer offering financial services to clients.
For example, investors can usually only withdraw cash from a stock sale three days after selling the securities, but a margin account allows investors to borrow funds for three days while they wait for their trades to clear.
“With a margin account, they don’t have to wait: They can access cash instantly,” says Watts. “You still have to pay interest for those three days, but it’s minuscule.” For instance, a margin loan of $10,000 at 5 percent interest would involve interest costs of less than $2 per day.
Boosts returns in bull markets
Watts says his more active clients use a margin account to borrow money to invest with, but he warns that such an investment strategy is best left for a full-time trader.
“If you’re in front of your terminal every day, you have strict loss limits and you have a trader mentality, margin investing can be a great thing in up markets. But investors should only do it when the market is going to keep going up and have very strict loss limits,” says Watts.
The problem is not knowing when the market might suddenly reverse course, he adds. “If you have a major disruptive event, prices can move pretty quickly against you, and you could end up owing a lot of money in a couple days. Anyone who invests on margin needs to keep a close eye on their portfolio, every day.”
Why Does Buying on Margin Matter?
Buying on margin allows investors to make investments with their brokers’ money. They act as leverage and can thus magnify gains. But they can also magnify losses, and in some cases, a brokerage firm can sell an investor’s securities without notification or even sue if the investor does not fulfill a margin call. For these reasons, margin accounts are generally for more sophisticated investors who understand and can handle the risks involved.
Now let’s recap other key points in this tutorial:
- Buying on margin is borrowing money from a broker to purchase stock.
- Margin increases your buying power.
- An initial investment of at least $2,000 is required (minimum margin).
- You can borrow up to 50% of the purchase price of a stock (initial margin).
- You are required to keep a minimum amount of equity in your margin account that can range
from 25% – 40% (maintenance margin).
- Marginable securities act as collateral for the loan.
- Like any loan, you have to pay interest on the amount you borrow.
- Not all stocks qualify to be bought on margin.
- You must read the margin agreement and understand its implications.
- If the equity in your account falls below the maintenance margin, the brokerage will issue a margin call.
- Margin calls can result in you having to liquidate stocks or add more cash to the account.
- Brokers may be able to sell your securities without consulting you.
- Margin means leverage.
- The advantage of margin is that if you pick right, you win big.
- The downside of margin is that you can lose more money than you originally invested.
- Buying on margin is definitely not for everybody.
- Margin trading is extremely risky.