Buying On Margin

Buying on margin is the purchase of an asset by using leverage and borrowing the balance from a bank or broker. Buying on margin refers to the initial or down payment made to the broker for the asset being purchased; for example, 10 percent down and 90 percent financed. The collateral for the borrowed funds is the marginable securities in the investor's account. Before buying on margin, an investor needs to be approved and open a margin account with his or her broker. The buying power you have in your brokerage account reflects the total dollar amount of purchases you can make using your cash plus available margin capacity. In addition to buying on margin, short sellers of stock also use margin to borrow and then sell those shares.

In the United States, the Federal Reserve Board regulates the amount of margin that an investor must pay for a security. As of 2019, the board requires an investor to fund at least 50 percent of a security's purchase price with cash. The investor may borrow the remaining 50 percent from a broker or a dealer.

As with any loan, when you buy securities on margin you have to eventually pay back the money you borrow plus interest, which varies by brokerage firm on a given loan amount. That said, interest rates for margin trades are typically lower than alternatives such as credit cards or personal loans. There is also no set repayment schedule; instead, monthly interest charges accrue to your brokerage account, where you can repay the principal at your convenience. In addition, margin interest can be tax-deductible if you use the margin to purchase taxable investments subject to certain limitations.

The key thing to remember is that you are investing with borrowed money. Buying on margin offers investors some definite benefits, but the practice is also fraught with risk. Using this kind of leverage to purchase securities with someone else's money amplifies gains when the value of those securities increases, but it magnifies losses when the securities decline in value.

To see how buying on margin works, we are going to simplify by taking out the monthly interest costs. Although interest does impact returns and losses, it is not as significant as the margin principal itself.

Let's look at an investor who purchases 100 shares of Company XYZ stock at $50 per share. He funds half the purchase price with his own money and the other half he buys on margin, making his initial cash outlay $2,500. After a year, the share price doubles to $100. The investor sells his shares for $10,000 and pays back his broker the $2,500 he borrowed for the initial purchase. Ultimately, he triples his money, making $7,500 on a $2,500 investment. Had he purchased the same number of shares outright using 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 falls by half, to $25. The investor sells at a loss and receives $2,500. Since this equals the amount he owes his broker, he loses 100 percent of his investment on the deal. Had he not used margin to make his initial investment, he still would have lost money, but he would only have lost 50 percent of his investment - $1,250 instead of $2,500.

Based on one's creditworthiness and other factors, 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. 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 percent, or $5,000. As soon as the investor's equity dips even a dollar below $5,000, the investor may receive a margin call. When this happens, the broker calls the investor and demands that the investor bring his balance back to the required maintenance margin level. The investor can do this by depositing additional cash into his brokerage account or by selling securities that he purchased with borrowed money. If you do not do this, the broker may begin to sell off your investments to restore the maintenance 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. That said, some types of trading like commodity futures trading are almost always purchased using margin while other securities such as options contracts are not marginable and must be purchased using 100 percent cash. Not everyone is built to trade futures or options, however, and for most individual investors primarily focused on stocks and bonds, buying on margin introduces an unnecessary level of risk into the equation.