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Buying on Margin and the Risks Involved

buying on margin

What Is Buying on Margin?

Buying on margin is the use of borrowed money to purchase securities. When you buy on margin, you only need to put down a fraction of the total purchase price.

Margin trading is a form of trading in which an investor borrows money from their broker to trade stocks and other securities. Margin traders are speculating that their investments will increase in value, with the hope that they can pay back the loan and make a profit.

The margin is the amount of money that you borrow from your broker and it is usually expressed as a percentage of the purchase price. For example, if you are buying stocks on 50% margin, then you would be borrowing 50% of the purchase price and paying for the rest with your own cash or cash equivalent.

For example, let’s assume you purchase $10,000 worth of shares with $5,000 of your own funds and by borrowing the remaining $5,000. This involves buying on a 50% margin since the borrowed amount of $5,000 represents 50% of the $10,000 purchase price.

Buying on margin can be risky because if the market moves against you, then your losses will increase in proportion to how much leverage you use.

How Does Buying Stock On Margin Work?

Buying on margin involves borrowing money from your broker at a fixed interest rate. A 5% margin interest rate means you can borrow $5,000 for less than $1 in interest cost per day. Let’s walk through an example that represents a successful trade using margin, and a failed trade that risks your entire account balance.

Let’s assume you have $5,000 USD in cash and you borrow another $5,000 on margin. This means you’re buying stocks at 50% margin which has elevated risk. Using the $10,000 you can buy 100 shares of a stock at $100 a share. If the stock increases to $150, your total holdings increase to $15,000 which equates to a $5,000 gain after returning the $5,000 borrowed amount plus margin fees.

This is opposed to a $2,500 gain if you were to purchase the shares without margin and simply using the $5,000 cash amount. This is considered a successful trade since you managed to increase your account balance and pay back the borrowed amount.

On the flip side, if those shares went down to $50 each, your total holdings would decrease to $5,000 which represents a $5,000 loss. Since you still need to pay the margin of $5,000 alongside any additional interest, this trade would empty your account. Without margin this trade would have decreased your holdings from $5,000 to $2,500 which represents a $2,500 loss and does not involve any margin fees.

This example illustrates a failed trade that would lose your portfolio balance and still require you to pay interest and any commission fees.

Buying On Margin Requirements & Regulations

There are several requirements and regulations involved with borrowing on margin. Specifically they pertain to initial margin requirements and margin maintenance requirements. 

The Federal Reserve sets regulations for the initial margin requirements. The current regulations state that an individual must fund 50% of the purchase price of a security. This means that traders and investors can buy stocks with up to 50% margin.

Similar to the previous example, you can invest $10,000 using $5,000 of your own funds by buying on 50% margin. You can not invest $15,000 by using $5,000 of your own funds since that represents a loan of $10,000 which would involve buying on more than 50% margin.

Furthermore, FINRA has set the minimum margin maintenance to 25% of the total portfolio value in a margin account. Margin maintenance requirements outline the minimum portfolio value you need to maintain before being issued a margin call. A margin call is when the broker sells your stocks in order to recoup the borrowed margin.

According to FINRA, the equity or cash portion in your portfolio should always be above 25% of the account balance to avoid a margin call. For example, if you borrow $4,000 on margin, your account balance should stay above $5,000 in order to avoid risking a margin call by your broker.

In addition to regulations set by the Federal Reserve and FINRA, each broker can have their own specific requirements for borrowing on margin. Since lending funds represents a risk to brokers, they have control over margin requirements and can choose to issue a margin call in order to recoup their funds if the account holder does not satisfy those requirements. It’s also worth noting that margin maintenance can fluctuate based on the volatility of the assets purchased.

Most brokers require special permissions to enable margin trading. This usually involves a questionnaire asking about your stock trading experience consenting to the risk associate with margin trading.

What are the Pros and Cons of Investing On Margins?

Buying on margin involves several pro’s and con’s that are important to understand when considering margin investing.

A major benefit of margin investing is the opportunity to gain leverage during opportunistic trades that can increase your gain. In the former example we saw that it’s possible to double your gain by buying stocks with 50% margin since you double your purchasing power and therefore the respective increase in value. In addition, buying on margin allows you to borrow money while waiting for additional cash to become available.

There’s often a delay from the time you deposit funds to your brokerage account to the point where they become available for trading. Similarly, when selling certain securities, there may be a hold period before you can reuse those funds to purchase additional assets. Buying on margin allows you to borrow money for a transaction even if your funds are not ready. This allows you to opportunistically enter trades and investments with more flexibility.

The primary downside of buying on margin revolves around the increased risk associated with leveraging borrowed money. Buying on margin can lead to a greater loss than the initial money invested. In an earlier example we saw that if the stocks purchased on 50% margin decrease by 50%, you stand to lose the entire initial investment plus margin fees and commissions.

This outsized risk is one of the reasons there are rules and requirements involved in margin trading. Furthermore, buying on margin becomes dangerous when a trade goes poorly and can risk triggering a margin call.

A margin call occurs when the equity in your portfolio drops below the maintenance margin. This allows the broker to sell your position to recoup the borrowed money. This can happen during an unfavorable situation where the stock temporarily dips and triggers a liquidation of your portfolio. In addition, buying on margin can unfavorably impact your credit score since it’s treated as taking a loan from a broker. Many of these cons to buying on margin makes it a risky technique that is often left to professionals.

Conclusion – Should You Consider “Buying On Margin?”

Buying on Margin is an advanced trading tool that presents elevated risk. For most beginners, buying on margin doesn’t make sense when looking at the risk-reward. The risk associated with margin trading is further elevated during times of uncertainty and in assets that can fluctuate drastically in price.

If you’re considering using margin, it’s important to understand concepts such as initial margin and maintenance margin. Furthermore, it’s important to understand that margin maintenance requirements can fluctuate depending on the stocks being purchased and that there are fees associated with margin investing.

Margin investing enables increased liquidity and higher potential upside for successful trades. However, margin investing also presents a higher downside risk alongside fees that must be paid back even if the entire portfolio value is lost. Therefore buying on margin is not a beginner concept and it’s a tool used by advanced traders that have experience managing risk.

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