Monday, May 27, 2019

Buying On Margin: How It Works and What To Watch Out For

"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. 

 

How Does Margin Work?

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.


The Risks

Margin accounts can be very risky and they are not for everyone. Before opening a margin account, be aware that:
  • You can lose more money than you have invested;
  • You may have to deposit additional cash or securities in your account on short notice to cover market losses;
  • You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
  • Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.
You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines.

Know the Margin Rules

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.
Tip: Not all securities can be purchased on margin.
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.


Margin Calls

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.
Tip: Your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm's maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.
  • Margin accounts involve a great deal more risk than cash accounts, where you fully pay for the securities you purchase. You may lose more than your initial investment when buying on margin. If you cannot afford to do so, then margin buying is not for you.
  • Read the margin agreement, and ask your broker questions about how a margin account works and whether it's appropriate for you to trade on margin. Your broker should explain the terms and conditions of the margin agreement.
  • Know how much you will be charged on money you borrow from your broker, and know how these costs affect your overall return.
  • Remember that your brokerage firm can sell your securities without notice to you when you don't have sufficient equity in your margin account.

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