Buying on Margin: How It’s Done, Risks and Rewards
SB
Summary:
Buying on margin is a financial strategy that involves borrowing money to invest in assets. This article explores what buying on margin means, its advantages, disadvantages, and why it can be a risky venture. Learn how to buy on margin, who should consider it, and its historical significance. Discover how this practice can amplify both gains and losses, making it essential to understand before using it in your investment strategy.
Compare Brokerage Services
Compare multiple vetted providers. Discover your best option.
Buying on margin: How it’s done, risks & rewards
Buying on margin is a financial practice where an investor purchases assets by borrowing a portion of the total cost from a bank or broker. In this article, we’ll delve into the concept of buying on margin, its underlying principles, and the potential risks and rewards associated with it. Whether you’re a seasoned investor or just starting, understanding buying on margin is crucial to making informed financial decisions.
Understanding buying on margin
The term “buying on margin” means that you’re using borrowed money to invest in assets. Typically, an investor provides a certain percentage of the asset’s price upfront (usually 50% or less), and the remaining balance is financed through a broker or a dealer. The assets held in your brokerage account serve as collateral for this borrowed money.
While Federal Reserve Regulation T mandates a minimum 50% cash or collateral requirement for buying on margin, many brokers impose higher margin requirements. Some assets may not be eligible for margin purchases.
Just like any loan, when you buy securities on margin, you’ll eventually need to repay the borrowed amount plus interest, which varies among brokerage firms. This monthly interest is charged to your brokerage account.
Essentially, buying on margin means investing with borrowed funds, making it a risky endeavor, especially if you have limited funds at your disposal.
Buying on margin example
Let’s illustrate how buying on margin works with an example. Suppose you want to purchase 100 shares of Company XYZ stock, each priced at $100. You decide to fund half of the purchase price with your own money and borrow the other half on margin, resulting in an initial cash outlay of $5,000.
One year later, the share price increases to $200, and you sell your shares for $20,000, paying back the broker the $5,000 borrowed for the initial purchase. In this scenario, you triple your money, earning $15,000 on a $5,000 investment. Had you used your own money to buy the shares, you would have only doubled your investment to $10,000.
Now, consider the share price falls by half to $50 instead of doubling. In this case, you sell the shares at a loss, receiving $5,000, which equals the amount owed to the broker. Here, you lose 100% of your investment. If you hadn’t used margin, your loss would have been limited to 50% of your investment—$2,500 instead of $5,000.
How to buy on margin
The broker determines the minimum or initial margin requirement and the maintenance margin, which must be maintained in your account before you can start buying on margin. These amounts are influenced by your creditworthiness. A maintenance margin is the minimum balance that must be retained in your brokerage account.
For instance, if you deposit $15,000, and the maintenance margin is set at 50% or $7,500, your account may receive a margin call if your equity falls below $7,500. At this point, you’re required to deposit funds to restore the account balance to the required maintenance margin.
You can either deposit cash or sell securities bought with borrowed money to comply. Failure to do so may lead the broker to liquidate your collateral to restore the maintenance margin.
Who should buy on margin?
Generally, buying on margin isn’t recommended for beginners. It requires a level of risk tolerance, close monitoring, and can be stressful, even for experienced investors. The high potential for loss during a market crash makes it particularly risky.
Some types of trading, like commodity futures trading, often involve margin, while others, like options contracts, are traditionally purchased with cash. Options trading on margin is allowed for options with over nine months until expiration, with an initial margin requirement of 75% of the cost.
For most individual investors focused on stocks and bonds, buying on margin introduces unnecessary risk.
Advantages and disadvantages of buying on margin
How does buying on margin work?
Margin trading involves depositing cash or securities as collateral to borrow cash for trading. In stock markets, you can typically borrow up to 50% of the total trade cost, with the rest coming from your margin collateral. Borrowed cash is used for speculative trades, and if you incur substantial losses, the broker may liquidate your collateral to cover them.
Why was buying on margin a problem?
Before the 1929 stock market crash, buying on margin encouraged speculation due to the potential for rapid gains with minimal investment. This led to a speculative bubble that inflated asset prices. When the bubble burst, many margin traders couldn’t repay their debts, contributing to the Great Depression.
Why is buying on margin risky?
While margin trading offers higher profit potential, it also entails higher losses. In some cases, a margin trader can lose more money than initially invested, necessitating additional assets to cover the difference.
The bottom line
Margin trading involves borrowing against your securities to make speculative trades. In a bullish market, it can yield higher returns. However, it also poses a significant risk of substantial losses, making it essential to fully understand before incorporating it into your investment strategy.
Frequently asked questions about buying on margin
What does “buying on margin” mean?
“Buying on margin” refers to a financial strategy in which an investor purchases assets by borrowing a portion of the total cost from a bank or broker. Instead of paying the full price upfront, the investor provides a percentage of the asset’s price, and the remaining amount is financed through a margin account with the broker. The assets held in the margin account serve as collateral for the borrowed funds.
How does buying on margin differ from a traditional cash purchase?
When you buy on margin, you are essentially using leverage by borrowing money to invest. In contrast, a traditional cash purchase involves using your own funds to buy assets outright. With margin trading, you can control a more substantial position than you could with your available cash alone, potentially amplifying both gains and losses.
What are the advantages of buying on margin?
The advantages of buying on margin include:
- Increased buying power: You can control a larger position in assets than you could with your own funds alone.
- Opportunities for higher returns: Amplified gains are possible when asset prices rise.
- No need to liquidate existing assets: You can use borrowed funds without selling your current investments.
What are the disadvantages and risks of buying on margin?
The disadvantages and risks of buying on margin include:
- Amplified losses: While gains can be magnified, so can losses, potentially resulting in significant financial setbacks.
- Interest charges: You must pay interest on the borrowed funds, affecting your overall returns.
- Maintenance margin: You must maintain a minimum account balance, subject to margin calls if not met.
- Margin calls: If your account value falls below the required maintenance margin, you may receive a margin call, requiring you to deposit additional funds or sell assets to cover the shortfall.
- Market volatility: Margin trading can be especially risky during periods of market turbulence.
Who should consider buying on margin?
Buying on margin is typically not recommended for beginners or those with a low risk tolerance. It requires a deep understanding of financial markets and close monitoring of investments. It is often better suited for experienced investors who can handle the added risk and volatility associated with margin trading.
Are there assets that cannot be purchased on margin?
Yes, some assets are not eligible for margin trading. The eligibility of assets for margin purchases may vary among brokers. Additionally, regulatory requirements may prohibit margin trading for certain types of securities. It’s essential to check with your broker regarding the specific assets available for margin trading.
How do I know if I’m eligible for margin trading with my broker?
Eligibility for margin trading typically depends on your creditworthiness and financial situation. Brokers assess your suitability for margin trading by evaluating factors such as your credit history, account size, and investment experience. It’s advisable to contact your broker to determine whether you meet their criteria for margin trading.
What is the difference between an initial margin and a maintenance margin?
The initial margin is the minimum amount of cash or collateral that you must deposit with your broker to initiate a margin trade. It is the upfront payment required to borrow funds for trading. The maintenance margin, on the other hand, is the minimum account balance that you must maintain after initiating the trade. If your account value falls below the maintenance margin due to losses, you may receive a margin call.
How can I avoid margin calls when buying on margin?
To avoid margin calls, it’s essential to monitor your margin account closely and ensure that your account value remains above the maintenance margin level. You can achieve this by managing your trades effectively, setting stop-loss orders, and having a risk management strategy in place. Additionally, depositing additional funds into your account can help maintain a buffer above the maintenance margin.
Is buying on margin suitable for long-term investors?
Buying on margin is generally not recommended for long-term investors who intend to hold assets for extended periods. It is a strategy often used by active traders and speculators seeking short-term gains. Long-term investors typically focus on a buy-and-hold strategy and are less exposed to the short-term price fluctuations that margin trading can amplify.
Key takeaways
- Buying on margin involves investing with borrowed money, amplifying both gains and losses.
- It’s crucial to understand the risks and advantages before considering buying on margin.
- Margin trading requires maintaining a minimum balance in your brokerage account, subject to margin calls if not met.
Share this post: