Do you have a healthy appetite for risk? Do you have at least several thousand dollars burning a hole in your brokerage account? Do you like the idea of investing with money you don’t have in order to potentially gain higher returns? Welcome to margin buying – the art of borrowing money solely in order to invest it.
To buy any stock on margin, you will need to borrow money from your broker. In turn, there are requirements from the broker (as well as the Federal Reserve) that limit your ability to borrow money irresponsibly.
There are two types of margin to consider:
- Initial Margin – This is the amount of the stock purchase price that you are required to supply to make the transaction. Federal Reserve rules mandate that you have at least 50% of the funds for a stock purchase, limiting your borrowing for the purchase to 50%. Brokerages may require a higher amount, and 70% is not unusual.
- Maintenance Margin – Once the transaction has taken place, this is the minimum amount of money that you must keep in your account to maintain your stock holdings. Regulations call for a 25% minimum, but the number is often more like 30%. This is another reason why brokers require minimum values to trade on margin, with quantities anywhere from $2,000 and up.
As the value of the stock changes, you may be required to add more money into your account to maintain that margin. As the value of the stock rises, you need to have more funds in your account to keep the cash component above the maintenance margin value. Conversely, your account requirements drop if the stock drops in value.
However, if the stock drops too far, the value of your stock minus the amount you owe the broker may fall below the maintenance margin. You would owe the broker more than your stock is worth. In that case, you are subject to a margin call.
This means that you have a limited amount of time, usually 24 hours or less, to deposit more funds in your account or sell off some of your stock holdings until the cash in the account rises above the margin call.
If you fail to act on a margin call, the broker may sell off some or all your holdings without your approval to meet these requirements. The broker may even have the choice of which stock to sell. You will be required to sign a margin agreement that covers all of the rights and rules regarding margin calls and other limitations. Be sure you read them carefully.
Why would anyone take this risk? The rewards can be substantial, overwhelming the interest costs and transaction fees associated with buying on margin.
Let’s use a simplified example with a 50% initial margin and a 30% maintenance margin. You decide to buy $20,000 of stock with $10,000 of your account funds and $10,000 in borrowed funds. You need to maintain $6,000 in cash in your account as a maintenance margin.
If the stock price doubles, your stock is worth $40,000. If you decide to hold the stock, you need to maintain $12,000 in cash in your account to maintain your position. If you decide to cash in your stock and pay back the broker, you will receive slightly less than $30,000 ($40,000 value minus $10,000 borrowed minus some interest and transaction fees) on the $10,000 invested from your account.
Had you bought the $10,000 worth of stock without margin, your stock would be worth $20,000, which is what you would receive when you cash out. By buying on margin, you made an extra $10,000 minus the interest and transaction fees, which in any normal trading scheme will be far less than $10,000.
However, if the stock price drops below 50%, your stock will be worth less than the $10,000 you owe the broker, and a margin call follows. If you expect the stock to rebound, you are going to have to throw even more funds at it to maintain the position and avoid a margin call.
You can calculate the price at which a margin call would be required and monitor the price to take any pre-emptive action.
Buying on margin amplifies your gains or losses, and thus the potential risk and rewards are also amplified. Make sure you have the stomach for risk and sufficient resources to cover some level of losses before you proceed to buy on margin.