Purchasing on margin allows investors to borrow funds to acquire stocks. To engage in margin trading, you first need to open a margin account with your brokerage and deposit at least $2,000 in cash or securities that can be used as margin.
Typically, stocks, bonds, mutual funds, and ETFs are eligible for margin trading. By using these assets as collateral, you can borrow up to 50% of the purchase price of a security, assuming it’s anticipated to appreciate in value in the near term.
If your expectations are correct and you sell the stock at a higher price than your purchase cost, you can repay the loan along with interest and commissions, and keep the remaining profit. However, if the stock takes longer to appreciate than anticipated, interest charges will accumulate. Additionally, if the stock price declines, you’ll still need to repay the loan, sometimes on short notice, which can pose a significant risk.
Profit margin
The most compelling advantage of investing through a margin account is the potential for enhanced returns. For instance, if you buy 1,000 shares at $10 each, your total investment is $10,000. However, with margin buying, you only need to put up $5,000 and borrow the remaining $5,000.
If the stock price rises to $15, you can sell for $15,000. After repaying the $5,000 loan, you keep the $10,000 balance (minus interest and commissions). This results in a nearly 100% profit on your $5,000 investment. In contrast, if you had paid the full $10,000 out of pocket, your profit would be $5,000, representing a 50% return.
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Another advantage of buying on margin is that it can free up cash for further investments, allowing you to leverage or fully fund additional opportunities. However, the more you borrow, the more vigilant you need to be about price fluctuations and the possibility of margin calls, which may require you to add more funds to your account.
Margin calls
Despite its potential rewards, buying on margin carries significant risks. For instance, if the value of the stock you purchase drops substantially, you could lose not only your entire investment but also more. To safeguard brokerage firms from potential losses, FINRA (the Financial Industry Regulatory Authority) mandates that you maintain a margin account balance of at least 25% of the purchase price of any stock bought on margin.
CLOSING THE BARN DOOR
During severe market declines, investors who are heavily leveraged through margin purchases might struggle to meet margin calls. This can lead to panic selling to generate cash, which in turn exacerbates market declines. To mitigate such risks, the Federal Reserve implemented Regulation T, which restricts the leveraged portion of margin purchases to 50%.
Individual firms can set margin requirements higher than the industry standard—such as 30%—but they cannot set them lower. If the market value of your investment falls below the required minimum, your brokerage will issue a margin call. To meet this call, you must either deposit additional funds to restore your account to the required level or sell the stock, repay the loan, and accept the loss.
For instance, if you bought shares on margin at $10 each and their value drops to $7, your equity would be $2,000 (28.6% of the total value of the shares, calculated as $2,000 / $7,000). If your broker requires a 30% margin, you would need to add $100 to bring your margin account up to $2,100 (30% of $7,000).
Leveraging your stock investment
Leverage involves using borrowed money at a fixed interest rate to potentially earn a higher return. Much like a lever amplifies force, leverage allows you to amplify financial power with a relatively small amount of your own cash. Companies also employ leverage, known as trading on equity, by issuing both stocks and bonds. This strategy can boost earnings per share as the company uses the funds from bonds to expand operations. However, the company must also allocate some of its earnings to cover bond interest payments.
When a margin call occurs, there remains a buffer protecting your broker’s share — in this example, $5,000. If you don’t meet the margin call or sell the shares yourself, the broker has the right to sell other stocks in your margin account to cover the loss. You may not receive prior notice of such sales or have the opportunity to choose which stocks are sold. Your funds are at risk, and the broker can act to recover any remaining shortfall from your account.
Buying Stocks On Margin. How It Works? by Inna Rosputnia
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