What Is Buying on Margin?
Buying on margin occurs when an investor buys an asset by borrowing the balance from a bank or broker. Buying on margin refers to the initial payment made to the broker for the asset—for example, 10% down and 90% financed. The investor uses the marginable securities in their broker account as collateral.
The buying power an investor has in their brokerage account reflects the total dollar amount of purchases they can make with any margin capacity. Short sellers of stock use margin to trade shares.
Key Takeaways
- Buying on margin means 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 some or all of your portfolio to get your account back in balance.
Understanding Buying on Margin
The Federal Reserve Board sets the margins securities. As of 2023, under Federal Reserve Regulation T, an investor must fund at least 50% of a security's purchase price with cash or other collateral. The investor may borrow the remaining 50% from a broker or a dealer.
However, many brokers set higher margin requirements for their customers. In addition, some securities cannot be purchased on margin.
As with any loan, when an investor buys securities on margin, they must eventually pay back the money borrowed, plus interest, which varies by brokerage firm on a given loan amount. Monthly interest on the principal is charged to an investor's brokerage account.
Essentially, buying on margin implies that an individual is investing with borrowed money. Although there are benefits, the practice is thus risky for the investor with limited funds.
Buying on Margin Example
To see how buying on margin works, we are going to simplify the process by taking out the monthly interest costs. Although interest does impact returns and losses, it is not as significant as the margin principal itself.
Consider an investor who purchases 100 shares of Company XYZ stock at $100 per share. The investor funds half the purchase price with their own money and buys the other half on margin, bringing the initial cash outlay to $5,000. One year later, the share price rises to $200. The investor sells their shares for $20,000 and pays back the broker the $5,000 borrowed for the initial purchase.
Ultimately, in this case, the investor triples their money, making $15,000 on a $5,000 investment. If the investor had purchased the same number of shares using their own money, they would only have doubled their investment from $5,000 to $10,000.
Now, consider that instead of doubling after a year, the share price falls by half to $50. The investor sells at a loss and receives $5,000. Since this equals the amount owed to the broker, the investor loses 100% of their investment. If the investor had not used margin for their initial investment, the investor would still have lost money, but they would only have lost 50% of their investment—$2,500 instead of $5,000.
How to Buy on Margin
The broker sets the minimum or initial margin and the maintenance margin that must exist in the account before the investor can begin buying on margin. The amount is based largely on the investor's creditworthiness. A maintenance margin is required of the broker, which is a minimum balance that must be retained in the investor's brokerage account.
Suppose an investor deposits $15,000 and the maintenance margin is 50%, or $7,500. If the investor's equity dips below $7,500, the investor may receive a margin call. At this point, the investor is required by the broker to deposit funds to bring the balance in the account to the required maintenance margin.
The investor can deposit cash or sell securities purchased with borrowed money. If the investor does not comply, the broker may liquidate the investor's collateral to restore the maintenance margin.
Who Should Buy on Margin?
Generally speaking, buying on margin is not for beginners. It requires a certain amount of risk tolerance and any trade using margin needs to be closely monitored. Seeing a stock portfolio lose and gain value over time is often stressful enough for people without the added leverage. Furthermore, the high potential for loss during a stock market crash makes buying on margin particularly risky for even the most experienced investors.
However, some types of trading, such as commodity futures trading, are almost always purchased using margin while other securities, such as options contracts, have traditionally been purchased using all cash. Buyers of options can now buy equity options and equity index options on margin, provided the option has more than nine months until expiration. The initial (maintenance) margin requirement is 75% of the cost (market value) of a listed, long-term equity or equity index put or call option.
For most individual investors primarily focused on stocks and bonds, buying on margin introduces an unnecessary level of risk.
Advantages and Disadvantages of Buying on Margin
Opportunities for Higher Gains
Margin trading allows investors to leverage their existing assets to make much larger trades than they could make with their own assets. For skilled traders, this represents an opportunity to exploit market opportunities, even with relatively limited investment capital.
No Need to Liquidate Existing Assets
Margin trading allows a trader to leverage their existing assets without having to sell them. If a trader liquidates their existing stock for cash, they may generate a taxable event that could offset their potential investment gains. However, a trader who uses their existing stock as margin collateral will be able to trade without selling their stocks.
Risk of Higher Losses
While margin traders can make higher profits, they can also incur larger losses. It is even possible for a margin trader to lose more money than they originally had to invest—meaning that they would have to make up the difference with additional assets.
Margin Fees
In addition to risks, traders must also pay additional fees for their margin positions. Typically, this ranges at around 10%, depending on the federal funds rate.
For example, as of January 13, 2023, Fidelity Investments charged between 8.25% and 12.575% for margin loans, depending on the size of the trader's margin position. If a certain position takes a long time to generate a profit, these fees may offset any expected returns.
Buying on Margin Pros and Cons
Pros
Higher Returns
No need to liquidate existing assets
Cons
Higher Risks.
Additional margin fees.
How Does Buying on Margin Work?
Margin traders deposit cash or securities as collateral to borrow cash for trading. In stock markets, they can typically borrow up to 50% of the total cost of making a trade, with the rest coming from their margin collateral. They then use the borrowed cash to make speculative trades. If the trader loses too much money, the broker will liquidate the trader's collateral to make up for the loss.
Why Was Buying on Margin a Problem?
Prior to the 1929 stock market crash, margin trading encouraged speculation because traders were effectively able to make rapid gains with a relatively low investment. These gains encouraged more margin trading, creating a bubble that pushed asset prices higher. When the bubble collapsed, many of these margin traders owed money that they were not able to repay.
Why Is Buying on Margin Risky?
Margin trades allow larger gains than regular investments, but also higher losses. These gains can be enticing in bull markets, but when the trades fail, an investor can owe more money than they originally had to trade with.
The Bottom Line
Margin trading is when investors borrow cash against their securities in order to make speculative trades. In a bullish market, margin trades can offer traders much higher returns than they could get by simply investing their available assets. However, margin trading can also lead to much higher losses.
