Understanding Buying on Margin

Buying on margin involves investors purchasing assets by borrowing funds from banks or brokers. It entails an initial payment to the broker, such as a 10% down payment with 90% financed, using marginable securities as collateral in the broker account.

The buying power in a brokerage account reflects the total amount of purchases possible with available margin. Short sellers utilize margin for trading shares.

Key Takeaways

• Buying on margin means investing with borrowed funds.
• Margin trading amplifies gains and losses.
• If the account balance falls below the maintenance margin, the broker can liquidate some or all of the portfolio to rebalance the account.

Understanding Buying on Margin

The Federal Reserve Board establishes margins on securities. According to Federal Reserve Regulation T as of 2023, investors must fund at least 50% of a security’s purchase price in cash or other collateral, borrowing the remaining 50% from a broker or dealer.

Brokers often impose higher margin requirements, and certain securities are ineligible for margin purchase.

Like any loan, investors must eventually repay borrowed funds with interest. Monthly interest charges are debited from an investor’s brokerage account based on the principal balance.

Buying on margin involves investing with borrowed capital, posing risks for investors with limited funds despite its advantages.

Buying on Margin Example

To illustrate buying on margin, let’s simplify by excluding monthly interest costs. Although interest affects returns and losses, its impact is lesser compared to the principal amount on margin.

Consider an investor purchasing 100 shares of Company XYZ stock at $100 per share. In this scenario, the investor funds half the purchase and uses margin for the remainder. If the share price later doubles to $200, the investor sells, making a significant profit.

Conversely, if the share price halves to $50, the investor incurs a substantial loss, emphasizing the risk in margin trading.

How to Buy on Margin

Brokers establish the minimum and maintenance margin requirements based on the investor’s creditworthiness. Investors must maintain a minimum balance, known as the maintenance margin, in their brokerage account.

If an investor’s equity drops below the required maintenance margin, the broker may issue a margin call, prompting the investor to deposit additional funds to meet the threshold.

Investors can deposit cash or liquidate securities obtained with borrowed funds to address margin requirements. Failure to comply may lead the broker to liquidate collateral to restore the maintenance margin.

Who Should Buy on Margin?

Buying on margin is typically unsuitable for beginners due to its risk nature and the need for closely monitoring trades. This practice is particularly hazardous during market downturns, making it risky even for experienced investors.

While certain trading, like commodity futures, often involves margin, buying on margin in stocks and bonds poses unnecessary risk for most individual investors.

Advantages and Disadvantages of Buying on Margin

Opportunities for Higher Gains

Margin trading enables investors to leverage existing assets for larger trades, exploiting market opportunities with limited capital.

No Need to Liquidate Existing Assets

Traders can leverage existing assets without selling them, avoiding possible tax implications and enabling trading without liquidating stock holdings.

Risk of Higher Losses

While margin trading can yield higher profits, it also poses the risk of significant losses, potentially exceeding the initial investment amount.

Margin Fees

In addition to market risks, margin traders incur fees, typically around 10% based on the federal funds rate.

For instance, as of January 13, 2023, Fidelity Investments charges margin loan fees averaging between 8.25% and 12.575%, impacting potential returns.

Buying on Margin Pros and Cons

Pros

• Higher Returns

• No need to liquidate existing assets

Cons

• Higher Risks.

• Additional margin fees.

How Does Buying on Margin Work?

Margin traders deposit cash or securities as collateral to borrow cash for trading. In stock markets, they can typically borrow up to 50% of the total cost of making a trade, with the rest coming from their margin collateral. They then use the borrowed cash to make speculative trades. If the trader loses too much money, the broker will liquidate the trader’s collateral to make up for the loss.

Why Was Buying on Margin a Problem?

Prior to the 1929 stock market crash, margin trading encouraged speculation because traders were effectively able to make rapid gains with a relatively low investment. These gains encouraged more margin trading, creating a bubble that pushed asset prices higher. When the bubble collapsed, many of these margin traders owed money that they were not able to repay.

Why Is Buying on Margin Risky?

Margin trades allow larger gains than regular investments, but also higher losses. These gains can be enticing in bull markets, but when the trades fail, an investor can owe more money than they originally had to trade with.

The Bottom Line

Margin trading involves borrowing funds against securities for speculative trading. While it offers higher returns in bullish markets, it also poses substantial risks, emphasizing the need for cautious investing practices.