Buying Stock on Margin
Investing on margin is a high-risk strategy that can help you yield huge profits if executed properly or make you lose all of your assets if you are not careful. This article will help you better understand buying stock on margin and the risks involved.
What Is Buying Stock on Margin?
Buying stock on Margin means borrowing money from a broker in order to buy a stock and using as collateral your investment.
Margins are generally used by investors as a way to increase their purchasing power in order to be able to own more stock without paying for it in full.
Understanding How Margin Works
To illustrate better how margin works let's consider the following example:
You have bought a stock for $100 and its price rises to $150. If you have used cash to pay for the stock in full you will have earned 50% return. However, if you have bought the stock on margin by borrowing $50 from your broker and paying only $50 in cash, you will have earned 100% return on your investment.
Of course you will have to pay back what you have borrowed ($50) plus interest. Thus, if the stock price decreases the losses can be substantial and mount quickly.
Let's say the stock price have decreased to $50. Your losses will be 50% if you have bought the stock in cash in full. However, if you have bought it on margin borrowing those additional 50$ your losses would be 100% plus the interest you would owe your firm.
You should know that not all stocks can be bought on margin. The marginable stocks are regulated by the Federal Reserve Board. Individual brokerages may also forbid the purchase of certain stocks on margin.
Additionally, the Federal Reserve Board and a number of self-regulatory organizations (such as the NYSE and NASD) have certain rules that govern margin trading. Individual brokerages may establish their own rules as long as those requirements are at least as restrictive as the rules of the Federal Reserve Board and the self-regulatory organizations. Here are the key rules you should be aware of:
Before trading on margin, an initial investment of at least $2,000 or 100% of the purchase price (whichever is less) is required for your margin account. This required deposit is known as the "minimum margin". Some brokerages may require more than $2,000.
Once your margin account is open and operational, you may borrow up to 50% of the purchase price of the securities that can be bought on margin. This is known as the "initial margin". Some brokerage firms may require more than 50%.
When buying on margin you are required to keep a minimum amount of equity in your margin account. This minimum is known as the "maintenance requirement" or "maintenance margin". The equity in your account is calculated by subtracting what you owe to the brokerage firm from the value of your securities. Generally, the maintenance margin would be 25% of the total market value of your securities but many brokerage firms have higher maintenance margins.
Buying on Margin Risks
In addition to the possibility to lose more money than you have invested, buying on margin hides some other risks:
- In volatile markets you may be required to deposit on short notice additional cash or securities in your account if the stock price starts falling.
- If falling stock prices decrease the value of your securities, you may be forced to sell them or at least some of them.
- Your brokerage firm has the right to sell some or all of your securities (even at a substantial loss to you) without any notification in order to pay off the money they have lent you.
Protect yourself from the possible risks by knowing well how a margin works and getting familiar with your brokerage firm terms and charges.
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