The popular adage “it takes money to make money” couldn’t be truer on Wall Street. Realizing a 20% annual return could generate some significant cash, but not necessarily on an initial investment of only $500. Buying on margin enables investors to purchase an asset by paying the margin and borrowing the balance from a bank or broker, which helps leverage profitability and returns.
In this article, we’ll take a look at the history of buying on margin, mechanics of the trade, and some common risks and other considerations.
History of Buying on Margin
Margin trading has been available for a long time in the United States, but policies have changed dramatically. In the 1920s, margin requirements were very loose, with brokers requiring investors to put up very little of their own money. Leverage rates of up to 90% weren’t uncommon, which led to a high number of margin calls when the market fell, and eventually led to the 1929 crash.
See also an Illustrated History of Every S&P 500 Bear Market.
Since then, margin requirements have become more strict and regulated by the securities industry. Brokers are required to obtain a signature to open a margin account; a minimum initial investment of $2,000 is required; and investors can only borrow up to 50% of the stock’s purchase price. The Federal Reserve also limits the types of stocks that can be purchased on margin (e.g. few OTC or IPO stocks).
Despite these changes, buying on margin remains a risky endeavor, especially for investors new to the concept. Brokers have realized these tendencies and introduced their own limitations in order to help inexperienced investors avoid losing money. For example, many brokerages may implement their own margin requirements, minimum balances, and list of permitted securities.
Mechanics of Buying on Margin
The first step to buying stock on margin is opening a margin account, which differs from a traditional brokerage account. These accounts typically require $2,000 or more in minimum margin and have varying levels of maintenance margins, interest rates, and other dynamics. Investors should compare brokerages and understand these terms before they begin buying stock on margin.
Once a margin account has been established, investors can borrow up to 50% of the purchase price of the stock – known as initial margin. The loan can be kept as long as the investor desires, but the marginable securities in the account are held as collateral and interest charges accrue over time. When marginable stock is sold, the proceeds are used to first repay the broker loan and then go to the investor.
Be sure to read the Foolproof Guide to Trading Order Types if you do choose to trade on margin.
The broker’s maintenance margin specifies the minimum account balance that must be maintained before a broker will force the investor to either deposit more funds or sell the stock to pay down the loan – known as a margin call. Since interest charges accrue over time, the amount of the total loan increases and a greater return is required from the marginable stock in order to remain profitable.
Example of a Margin Trade
Suppose that an investor deposits $5,000 into a margin account. Since the investor is responsible for 50% of the purchase price, they have a combined buying power of $10,000 within the margin account. The investor may begin buying stock at any time and when the total amount surpasses the initial $5,000, then they begin borrowing from the broker and are responsible for the associated interest charges.
Since the broker provides capital on a percentage basis, the buying power of a margin account is constantly changing depending on the price movement of the marginable securities. Investors should keep a close eye on these metrics with the help of many broker tools that provide these insights. After all, being caught off-guard can result in rapid losses and unwanted selling.
Be sure to also see the Best Investments of All Time.
If the investor purchases $10,000 worth of stock and the account value drops to $7,500, then the investor has equity of just $2,500 ($7,500 – $5,000 = $2,500). With a maintenance margin of 25%, the investor has just $1,875 ($7,500 × 25% = $1,875). The $2,500 in equity is more than the $1,875 maintenance margin, so there is no margin call—but if the margin requirements were higher—the investor would be in trouble.
Risks and Other Considerations
Leverage is a double-edged sword that amplifies both gains and losses. When traders use margin in bull markets, it help improve returns, but the opposite is true in bear markets. Traders may be subject to margin calls when their position falls below a threshold that the bank or brokerage is comfortable with, requiring the trader to put up capital or face liquidation of their leveraged positions.
Let’s take a look at an example of successful and unsuccessful trades using both margin and non-margin accounts to see the different dynamics:
|Initial Value||Current Value||% Gain/Loss||$ Gain/Loss|
|Margin Gain||$4,000||$4,400||20%||$400 on $2,000|
|Normal Gain||$2,000||$2,200||10%||$200 on $2,000|
|Margin Loss||$4,000||$3,600||-20%||-$400 on $2,000|
|Normal Loss||$2,000||$1,800||-10%||-$200 on $2,000|
The accumulation of interest charges over time also increases the total debt and future interest charges in a snowball effect. For this reason, buying on margin is most commonly used for short-term trading rather than long-term investment. Investors may want to consider using long-term stock options—such as LEAPS—as an alternative and potentially less expensive strategy.
The Bottom Line
Buying on margin is an attractive strategy for leveraging returns for short-term trading, although there are many risks that investors should carefully consider. In addition to the amplification of declines, investors should be aware of the potential for margin calls that can lead to rapid declines in value. Long-term investors may want to consider alternative strategies that may be less risky.
If you’ve enjoyed this article, sign up for the free TraderHQ newsletter; we’ll send you similar content weekly.