What is margin buying?
Buying on margin is the purchase of an asset using leverage and borrowing the balance from a bank or broker. The margin purchase refers to the down payment or deposit paid to the broker for the asset purchased; for example, 10 percent down and 90 percent funded. The guarantee for borrowed funds consists of securities negotiable in the investor’s account. Before buying on margin, an investor must be approved and open a margin account with his broker. The purchasing power you have in your brokerage account reflects the total amount of purchases you can make using your money plus the margin capacity available. In addition to buying on margin, short sellers of stocks also use margin to borrow and sell those stocks.
In the United States, the Federal Reserve Board regulates the amount of margin an investor must pay for a security. From 2019, the board of directors requires an investor to finance at least 50% of the purchase price of a security in cash. The investor can borrow the remaining 50% from a broker or broker.
Understanding margin buying
As with any loan, when you buy margin securities, you may have to pay back the money you borrow plus interest, which varies with the brokerage firm for a given loan amount. That said, interest rates for margin transactions are generally lower than those of alternatives such as credit cards or personal loans. There is also no fixed repayment schedule; instead, monthly interest charges accrue to your brokerage account, where you can repay the principal at your convenience. In addition, interest on margin may be tax deductible if you use the margin to purchase taxable investments subject to certain limitations.
The bottom line is that you are investing with borrowed money. Buying on margin offers investors certain advantages, but the practice is also fraught with risks. Using this type of leverage to buy securities with someone else’s money amplifies the gains when the value of these securities increases, but it amplifies the losses when the value of the securities decreases.
Key points to remember
- Buying on margin means that you are investing with borrowed money.
- Buying on margin amplifies both gains and losses.
- If your account falls below the maintenance margin, your broker can sell part or all of your portfolio to restore balance to your account.
How margin buying works
To see how margin buying works, let’s simplify by removing the monthly interest charges. Although interest has an impact on returns and losses, it is not as important as the principal of the margin itself.
Let’s look at an investor who buys 100 shares of XYZ at $ 50 a share. He finances half the purchase price with his own money and the other half which he buys on margin, which allows him to spend $ 2,500. After a year, the share price doubles to $ 100. The investor sells his shares for $ 10,000 and reimburses his broker for the $ 2,500 he borrowed for the initial purchase. In the end, he triples his money, earning $ 7,500 on an investment of $ 2,500. If he had bought the same number of shares with his own money, he would only have doubled his money, from $ 2,500 to $ 5,000.
Now consider that instead of doubling after a year, the share price drops in half to $ 25. The investor sells at a loss and receives $ 2,500. As this is equivalent to the amount he owes to his broker, he loses 100% of his investment in the transaction. If he hadn’t used the margin to make his initial investment, he would still have lost money, but he would have lost only 50% of his investment – $ 1,250 instead of $ 2,500.
How to buy on margin
Depending on his credit worthiness and other factors, the broker defines the minimum or initial margin and the maintenance margin that must exist in the account before the investor can start buying on margin. The maintenance margin refers to the minimum amount of money that must exist in the account before the broker forces the investor to deposit more money.
Suppose an investor deposits $ 10,000 and the maintenance margin is 50%, or $ 5,000. As soon as the investor’s equity drops even one dollar below $ 5,000, the investor can receive a margin call. When this happens, the broker calls the investor and asks him to bring his balance back to the required maintenance margin level. Investors can do this by depositing additional money into their brokerage account or by selling securities they have purchased with borrowed money. If you don’t, the broker can start selling your investments to restore the maintenance margin.
Who should buy on margin?
In general, buying on margin is not intended for beginners. This requires a certain tolerance for risk and any trade using a margin must be closely monitored. Seeing a stock portfolio lose and gain value over time is often stressful enough for people without additional leverage. That said, certain types of transactions such as commodity futures are almost always bought with a margin while other securities such as option contracts are not negotiable and must be purchased 100% in cash. However, not everyone is designed to trade futures or options, and for most individual investors focused primarily on stocks and bonds, buying on margin introduces an unnecessary level of risk into the market. equation.