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Buying on Margin – What Does it Mean – Advantages – Risks – Examples

What Is Buying on Margin?

Buying on MarginBuying on margin means borrowing money from your brokerage company and using that money to buy stocks. It is no different than taking out a loan to buy stocks.  If the stock price goes up, you can repay the loan with the gain.  If the stock price goes down, you will have to repay the loan with additional cash to top up your trading account.

In other words, you’re simply taking out a loan, buying stocks with the lent money, and eventually repaying that loan at a later date.  Also, there is interest to consider on the borrowed funds.

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. (Source: investopedia.com)

Buying on Margin – Rules and Regulations

The Federal Reserve Board sets the margins on securities. As of 2019, the board requires an investor to fund at least 50% of a security’s purchase price with cash. The investor may borrow the remaining 50% from a broker or a dealer. As with any loan, when an investor buys securities on margin, they must eventually pay back the money borrowed.  Additional interest is due as well.  Interest rates vary by brokerage firms and the size of the trading account and loan amount. The monthly interest on the principal is charged directly to an investor’s brokerage account.

Essentially, buying on margin means an individual is investing with borrowed money. Although there are benefits, the practice is risky.  Especially for an investor with limited funds.

How Buying on Margin Works

Consider an investor who purchases 100 shares of Johnson & Jackson Corp stock at $200 per share. The investor funds half the purchase price with their own money and buys the other half on margin.  This makes the initial cash outlay $10,000 and a margin loan of $10,000. One year later, the share price rises to $300. The investor sells the shares for $30,000 and pays back the broker the $10,000 borrowed for the initial purchase.

Example when share prices rise

In this case, the investor doubles their money, making $20,000 on a $10,000 cash outlay. If the investor had purchased the same number of shares using their own money, they would only have only realized a 50% return instead of a 100% return. Their investment still went from $20,000 to $30,000.  But, using all cash for the entire $20,000 purchase, their gain calculates to 50%.  Using margin to fund half the purchase, their return is 100% or double their cash outlay.

Example when share prices fall

Now, what happens when share prices decline?  Instead of doubling after a year, what if the share price falls by half to $100. The investor sells at a loss and receives $10,000. This equals the amount owed to the broker, so the investor loses 100% of their investment and ends up with nothing. 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, $5,000 instead of $10,000.  The investor would have only been able to purchase 50 shares at $200.  As a result, the investor would still own 50 shares of Johnson & Jackson stock worth $5,000.

For simplicity, the above examples do not consider monthly interest charges.  Of course, interest impacts returns and losses.  However, it is not as significant as the margin principal itself.

How to Buy on Margin

The broker sets the minimum or initial margin and the maintenance margin.  That is the amount 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 by the broker, which is a minimum balance that must be retained in the investor’s brokerage account.

Suppose an investor deposits $25,000 and the maintenance margin is 50%, or $12,500. If the investor’s equity dips below $12,500, the investor may receive a margin call. At this point, the investor is required by the broker to deposit additional funds.  Topping up to bring the balance in the account to the required maintenance margin. The investor can deposit cash or sell securities. If the investor does not comply, the broker may sell off the investments held by the investor to restore the maintenance margin.

Buying on Margin – Advantages

Why use margin? It’s all about leverage. Just as companies borrow money to invest in projects, investors can borrow money and leverage the cash they invest. Leverage amplifies every point that a stock goes up. If you pick the right investment, margin can dramatically increase your profit.  If you choose correctly, margin does offer the opportunity to amplify your returns.

A 50% initial margin allows you to buy up to twice as much stock as you could with just the cash in your account. As a result, you can make significantly more gains by using a margin account than by trading from a pure cash position. What really matters is whether your stock rises or not.

Example

Like the previous example, let’s continue with $20,000 worth of securities bought using $10,000 of margin and $10,000 of cash. VacTech Co. is trading at $200 and you feel that it will rise dramatically. Normally, you’d only be able to buy 50 shares (50 x $200 = $10,000). However, by investing on margin, you have the ability to buy 100 shares (100 x $200 = $20,000).  VacTech Co. then comes up with a new vaccine and the price of shares jumps 50%.

Your investment is now worth $30,000 (100 shares x $300) and you decide to cash out. After paying back your broker the $10,000 you originally borrowed, you get $20,000, $10,000 of which is profit. That’s a 100% return even though the stock only went up 50%. (Note: to simplify this transaction, we didn’t take into account commissions and interest. Otherwise, these costs would be deducted from your profit.)

Buying on Margin – Risks

However, margin accounts are risky and not for all investors. Leverage is a double-edged sword, amplifying losses and gains to the same degree. In fact, one of the definitions of risk is the degree that an asset swings in price. Because leverage amplifies these swings then, by definition, it increases the risk of your portfolio.

In a cash account, there is always a chance that the stock will rebound. If the fundamentals of a company don’t change, you may want to hold on for the recovery. Your losses are paper losses until you sell. However, in a margin account, your broker can sell off your securities if the stock price dives. When that happens, your losses are locked in and you won’t be able to participate in any future rebounds that may take place. If you are new to investing, think twice before experimenting with margin loans. Even if you feel ready for margin trading, remember that you don’t have to borrow the whole 50%. With any investment, only invest on the margin the money you can afford to lose.

Example

Returning to the example, say that instead of moving up 50%, your shares fell 50%. Now your investment would be worth $10,000 (100 shares x $100). You sell the stock, pay back your broker the $10,000, and end up with a big fat zero. That’s a 100% loss, plus commissions and interest. Buying on margin is the only stock-based investment where you stand to lose more money than you invested. A dive of 50% or more will cause you to lose more than 100%, with interest and commissions on top of that. (Source: stockwinners.com)

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. The high potential for loss during a stock market downturn makes buying on margin particularly risky for even the most experienced investors.  Most individual investors primarily focus on stocks and bonds.  For them, buying on margin introduces an unnecessary level of risk.

However, some types of trading, such as commodity futures trading, are almost always purchased using margin.  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.  However, this is provided the option has more than nine (9) 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.  (Source: cboe.com) 

Buying on Margin and the Great Depression

Many people bought stocks on the margin in the late 1920s.  The bull market of the roaring 20’s conditioned investors to believe stock prices would keep going up forever.  As a result, investors were buying on margin.  They became overconfident about the prospects for the stocks and were even willing to pay inflated prices for the stocks.  This made stock prices go up more than they should have.  Eventually, the bubble burst, and stock prices dropped.

When the stock prices continued dropping, people who had borrowed to buy on the margin were in trouble.  They could not repay their loans because the stock prices had not risen.  When they could not repay their loans, they went broke.  However, so many people could not repay loans that banks began failing.  This snowball effect helped to bring about the Great Depression.

Up Next: What Is Actuarial Science?

Actuarial ScienceActuarial science is a discipline that uses mathematics, statistics, and economics to assesses financial risks in the insurance and finance fields. Actuarial science majors use this training in mathematics and economics to solve business problems that identify and manage financial risk.

Actuaries apply the mathematics of probability and statistics to define, analyze, and solve the financial implications of uncertain future events. Traditional actuarial science largely revolves around the analysis of mortality and the production of life tables.  In banking, it manages the application of compound interest.

Simply put, actuarial science is the systematic study of data.  For example, data that relate to mortality or financial loss due to an adverse event.  Actuaries analyze trends to make reasonable assumptions when there are no reliable data.  The goal is to develop reliable models of what the future may look like. This is then used in the design and pricing of insurance products to provide financial stability and protection against losses.

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