Buying on margin lets investors borrow some of the money they need to buy stocks. To buy on margin, you open a margin account with your brokerage firm and deposit a minimum of $2,000 in cash or marginable securities.
Most stocks, bonds, mutual funds, and ETFs qualify. With those assets as collateral, you’re able to borrow up to 50% of the purchase price of a security that is expected to increase in value in the short term.
If you are correct in your expectation and can sell the stock at a higher price than it cost you to buy, you can repay the loan plus interest and commissions and keep the profit. But if it takes longer than you expect for the price to rise, interest charges mount. And, if the stock price falls, which it certainly could do, the loan must still be repaid, sometimes very quickly.
The most persuasive reason to invest through a margin account is the potential for a better return. In the example shown here, if you buy 1000 shares at $10 a share, your total cost is $10, 000. But buying on margin, you put up $5,000 and borrow the remaining $5,000.
If you sell when the stock price rises to $15, your account is credited with $15,000. You repay the $5,000 and keep the $10,000 balance (minus interest and commissions). The $5,000 is almost a 100% profit on your outlay. Had you paid the full $10,000 with your own money, your percentage profit would be 50%, though still $5,000.
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Another appeal of buying on margin is that it can free up cash for additional investments, which you could also leverage or pay for in full. The more you borrow, though, the more attentive you need to be to changing prices and the amounts you may be required to add to your account if you receive a margin call.
Despite its potential rewards, buying on margin can be very risky. For example, the value of the stock you buy could drop so much that you could lose the entire amount you invested and more. To protect brokerage firms from losses, FINRA, the Financial Industry Regulatory Authority, requires you to maintain a margin account balance of at least 25% of the purchase price of any stock you buy on margin.
CLOSING THE BARN DOOR
During dramatic drops in the market, investors who are heavily leveraged because they’ve bought on margin may not be able to meet their margin calls. The result is panic selling to raise cash and further declines in the market. That’s one reason the Federal Reserve instituted Regulation T, which limits the leveraged portion of any margin purchase to 50%.
Individual firms can require a higher margin level — say 30% — but not a lower one. If the market value of your investment falls below its required minimum, the firm issues a margin call. You must either meet the call by adding money to your account to bring it up to the required minimum, or sell the stock, pay back your loan in full, and take the loss.
For example, if shares you bought on margin for $10 a share declined to $7 a share, your equity would be $2,000, or 28.6% of the total value of the shares ($7,000 – $5,000 = $2,000 / $7,000 =0.286 or 28.6%). If your broker has a 30% margin requirement, you would have to add $100) to bring your margin account up to $2, 100 (30% of $7,000).
Leveraging your stock investment
Leverage means investing with money at a fixed rate of interest in the hope of earning a greater rate of return. Like the lever, the simple machine for which it is named, leverage lets you use a small amount of cash to exert a lot of financial power. Companies use leverage — called trading on equity — when they issue both stocks and bonds. Their earnings per share may increase because they expand operations with the money raised by bonds. But they must use some of the earnings to repay the interest on the bonds.
When the margin call comes, there’s still a cushion protecting your broker’s share — in this case, $5,000. Because your shares will be sold if you don’t meet the call or sell the shares yourself, your money is at risk. In fact, your broker could sell other stock in your margin account to recoup a loss that selling the shares didn’t cover. You may not be notified before such a sale occurs or be able to select the stock to be sold.
Buying Stocks On Margin. How It Works? by Inna Rosputnia
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