Buying on Margin

What Do You Get When You Buy On Margin?

When an investor buys an asset on margin, he or she borrows the remaining funds from a bank or broker. The first payment made to the broker for the asset—for example, 10% down and 90% financed—is referred to as buying on margin. The marginable securities in the investor's broker account are used as collateral.

The entire dollar amount of purchases an investor may make with any margin capacity is reflected in their brokerage account's purchasing power. Margin is used by stock short sellers to exchange shares.

TAKEAWAYS IMPORTANT

• Buying on margin entails making an investment with borrowed funds.

• Both gains and losses are amplified when you buy on margin.

• If your account goes below the maintenance margin, your broker may sell part or all of your portfolio to restore balance.

Understanding Margin Buying

The Federal Reserve Board is in charge of setting the margins on securities. As of 2019, the board mandates that an investor fund at least 50% of the acquisition price of a security with cash. A broker or a dealer may be able to lend the investor the remaining 50%.

When an investor buys shares on margin, they must eventually pay back the money borrowed, plus interest, which fluctuates depending on the brokerage business and the loan amount. An investor's brokerage account is paid monthly interest on the principal.

Essentially, purchasing on margin is making an investment with borrowed funds. Despite the advantages, the strategy is dangerous for investors with minimal assets.

What Is Margin Buying and How Does It Work?

We'll simplify the procedure by removing the monthly interest expenses to illustrate how purchasing on margin works. Although interest has an influence on returns and losses, it pales in comparison to the margin principal.

Consider an investor who pays $100 per share for 100 shares of Company XYZ stock. The investor pays half of the purchase price out of pocket and the other half on credit, bringing the total cash outlay to $5,000. After a year, the stock price has risen to $200. The investor sells their shares for $20,000 and repays the $5,000 loaned by the broker for the first purchase.

Finally, the investor triples their money in this scenario, making $15,000 on a $5,000 investment. If the investor had bought the same number of shares with their own money, their investment would have only increased from $5,000 to $10,000.

Consider if instead of increasing in value after a year, the stock price plummets to $50. The investor makes a $5,000 profit by selling at a loss. Because this is the same as the amount owing to the broker, the investor loses their whole investment. If the investor had not utilised margin for their original investment, they would have lost money as well, but only half of what they had invested—$2,500 instead of $5,000.

How to Make a Margin Purchase

Before an investor may begin purchasing on margin, the broker determines the minimum or initial margin as well as the maintenance margin that must be present in the account. The amount is mostly determined by the creditworthiness of the investor. The broker is obligated to maintain a maintenance margin, which is a minimum balance that must be maintained in the investor's brokerage account.

Let's say an investor puts down $15,000 with a 50% maintenance margin of $7,500. A margin call may be issued if the investor's equity falls below $7,500. The broker will now demand the investor to deposit monies to bring the account balance to the requisite maintenance margin. The investor has the option of depositing cash or selling shares that were acquired with borrowed funds. If the investor fails to comply, the broker may liquidate the investor's investments to recoup the maintenance margin.

Who Should Make a Margin Purchase?

Buying on margin is not for novices, in general. It necessitates a certain level of risk tolerance, and each margin deal must be properly managed. Having to watch a stock portfolio lose and gain value over time may be stressful enough without the extra leverage. Furthermore, even the most experienced investors should avoid buying on leverage due to the significant danger of losing money during a stock market crisis.

Some forms of trading, such as commodities futures trading, are virtually always done on margin, whilst other securities, such as options contracts, have typically been done with complete cash. Option buyers can now buy stock and equity index options on margin if the option is more than nine (9) months out from expiration. The initial (maintenance) margin requirement for a listed, long-term stock or equity index put or call option is 75 percent of the cost (market value). 

Buying on margin increases an unneeded amount of risk for most individual investors who are primarily focused on equities and bonds.