"Buying on margin" is borrowing money from your broker to buy a stock and using your investment as collateral. Investors generally use margin to increase their purchasing power so that they can own more stock without fully paying for it. But margin exposes investors to the potential for higher losses.
This Financial Guide discusses the basics of buying on margin, some of the pitfalls inherent in margin buying, whether this financial tool is for you and how you can best use it.
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Let's say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you'll earn a 50 percent return on your investment. But if you bought the stock on margin - paying $25 in cash and borrowing $25 from your broker - you'll earn a 100 percent return on the money you invested. Of course, you'll still owe your brokerage $25 plus interest.
The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let's say the stock you bought for $50 falls to $25. If you fully paid for the stock, you'll lose 50 percent of your money. But if you bought on margin, you'll lose 100 percent, and you still must come up with the interest you owe on the loan.
Margin accounts can be very risky and they are not for everyone. Before opening a margin account, be aware that:
You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines.
To open a margin account, you must sign a margin agreement. The agreement may either be part of your account agreement or separate. The margin agreement states that you must abide by the rules of the Federal Reserve Board, the New York Stock Exchange, the National Association of Securities Dealers, Inc., and the firm where you have set up your margin account.
As with most loans, the margin agreement explains the terms and conditions of the margin account. The agreement describes how the interest on the loan is calculated, how you are responsible for repaying the loan, and how the securities you purchase serve as collateral for the loan. Carefully review the agreement to determine what notice, if any, your firm must give you before selling your securities to collect the money you have borrowed.
The Federal Reserve Board and many self-regulatory organizations (SROs), such as the NYSE and NASD, have rules that govern margin trading. Brokerage firms can establish their own requirements as long as they are at least as restrictive as the Federal Reserve Board and SRO rules.
Here are some of the key rules you should know:
Before You Trade - Minimum Margin. Before trading on margin, the NYSE, and NASD, for example, requires you to deposit with your brokerage firm a minimum of $2,000 or 100 percent of the purchase price, whichever is less. This is known as the "minimum margin." Some firms may require you to deposit more than $2,000.
Amount You Can Borrow - Initial Margin. According to Regulation T of the Federal Reserve Board, you may borrow up to 50 percent of the purchase price of securities that can be purchased on margin. This is known as the "initial margin." Some firms require you to deposit more than 50 percent of the purchase price.
Amount You Need After You Trade - Maintenance Margin. After you buy stock on margin, the NYSE and NASD require you to keep a minimum amount of equity in your margin account. The equity in your account is the value of your securities less how much you owe to your brokerage firm. The rules require you to have at least 25 percent of the total market value of the securities in your margin account at all times. The 25 percent is called the "maintenance requirement." In fact, many brokerage firms have higher maintenance requirements, typically between 30 to 40 percent and sometimes higher, depending on the type of stock purchased.
If your account falls below the firm's maintenance requirement, your broker generally will make a margin call to ask you to deposit more cash or securities into your account. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm's maintenance requirement.