What Is Buying on Margin?
Buying on margin occurs when an investor purchases an asset by borrowing part of the total cost from a bank or broker. This strategy involves the initial payment made to the broker, such as a 10% down payment and 90% financed through borrowing. The investor uses the marginable securities in their account as collateral to secure the loan.
Key Takeaways
- Investing with Borrowed Funds: Buying on margin means leveraging borrowed money for investment.
- Amplified Gains and Losses: Margin trading can significantly amplify both gains and losses.
- Maintenance Margin Requirements: Should your account fall below the minimum maintenance margin, your broker may liquidate part or all of your portfolio to restore balance.
Understanding Buying on Margin
The Federal Reserve Board sets margin requirements for securities. As of 2023, under Federal Reserve Regulation T, an investor must fund at least 50% of a security’s purchase price with their own cash or collateral, borrowing the remaining 50% from a broker or dealer. Many brokers, however, impose higher margin requirements and some securities cannot be acquired on margin.
Borrowed funds must eventually be repaid with interest, which varies by brokerage firm and the loan amount. The accrued monthly interest on the principal is debited to the investor’s brokerage account.
Buying on margin equates to investing with borrowed money. While it offers certain benefits, the practice carries significant risk, especially for investors with limited funds.
Buying on Margin Example
To illustrate margin trading, let’s simplify the scenario by excluding monthly interest costs. Consider an investor who buys 100 shares of Company XYZ at $100 each, leveraging $5,000 of their funds and $5,000 borrowed on margin. When the stock price increases to $200 per share a year later, selling the investment yields $20,000. After repaying the $5,000 loan, the investor has tripled their initial $5,000 investment to $15,000.
Conversely, if the stock price drops to $50, selling results in just $5,000, enough to repay the borrowed amount, leading to a 100% loss of the original investment. Without borrowing, the investor would only have lost $2,500 — a 50% loss.
How to Buy on Margin
A broker sets the initial and maintenance margin requirements based on the investor’s creditworthiness. An investor depositing $15,000 must maintain 50% or $7,500 of that balance. Falling below triggers a margin call, requiring additional funds or liquidation of securities to meet the maintenance margin.
Who Should Buy on Margin?
Margin trading generally isn’t recommended for beginners due to the risk involved. It requires high-risk tolerance and constant monitoring. However, margin trading is common in certain domains like commodity futures, although it remains highly risky even for seasoned investors.
For most individual investors mainly focusing on stocks and bonds, margin trading is typically an unnecessary risk.
Advantages and Disadvantages of Buying on Margin
Opportunities for Higher Gains
Margin trading allows leveraging existing assets to make larger trades, creating opportunities for skilled traders to capitalize on market movements with limited initial capital.
No Need to Liquidate Existing Assets
Margin trading allows traders to leverage investments without selling them, preventing taxable events which could negate market gains.
Risk of Higher Losses
Margin accounts enable higher profits and equally significant losses, potentially leading traders to lose more than their initial investment.
Margin Fees
Margin trading incurs extra fees usually noted around 10%, influenced by the federal funds rate. Prolonged trades can see fees detract from expected returns.
Buying on Margin Pros and Cons
Pros
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Higher Returns
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No need to liquidate existing assets
Cons
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Higher Risks
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Additional margin fees
How Does Buying on Margin Work?
Margin trading involves depositing cash or securities as collateral to borrow up to 50% of trade costs in stock markets. This borrowed cash facilitates speculative trading, with potential asset liquidation by brokers if losses exceed acceptable limits.
Why Was Buying on Margin a Problem?
Before the 1929 crash, margin trading spurred speculation, encouraging acceleration gains on small investments and inflating prices. When the market plummeted, unpaid loans led to severe financial liabilities for traders.
Why Is Buying on Margin Risky?
Margin trading provides higher potential gains along with correspondingly greater losses. Gains in bullish markets entice investors although failed trades can result in liabilities exceeding initial investments.
The Bottom Line
Margin trading involves borrowing against securities to undertake speculative trades. While capable of yielding much higher returns in rising markets, it also magnifies possible losses equally. For most individual investors, the risk may outweigh the potential rewards.
Related Terms: Stock Market, Loan, Collateral, Short Selling, Federal Reserve, Interest Rates, Margin Call, Commodity Futures, Options Contracts.
References
- Financial Industry Regulatory Authority. “Margin Regulation”.
- Chicago Board of Exchanges. “Strategy-based Margin”.
- Fidelity Investments. “Margin Rates”.
