Investing in the margins Share:. Text size: aA aA aA. We've all heard of the lucky investor who made a killing by not only buying Apple when it was cheap, but by buying it on margin, effectively doubling his already hefty returns. We've also heard of the not-so-lucky investor who made a bad call on margin, was forced to sell at a steep loss and then to liquidate his profitable holdings when he received a margin call. The two stories are illustrative of the upside and downside of margin investing.
Buying on margin means you're buying stocks with money you've borrowed from your brokerage firm. It's appealing because you might in theory turn a profit using money you don't even have. But it's risky in that you can lose big if prices fall. Footnote 1.
To purchase a stock on margin, you first need to open a margin account. That's different from a typical brokerage cash account, although many brokerages will give you margin accounts automatically, unless you specifically tell them not to. Brokerages can set different minimum account balances, margins and maintenance minimums, as long as they are more stringent than the federal rules. The mechanics of buying on margin run as follows.
Not all securities are marginable. In general, penny stocks, over-the-counter Bulletin Board OTCBB securities or initial public offerings IPOs cannot be purchased on margin, and different brokerages have different restrictions.
What's more, brokerages may set maintenance minimums to correspond with the volatility of a stock. Our lucky Apple investor, flush with his recent success, next decides to buy two different stocks on margin. Proceeds of the sale are used in part to pay off the loan, but still leave him with a tidy profit even after trade commissions and interest expense on the loan are factored in.
His second purchase takes a different tack. The two transactions taken together might at first appear to be a wash, but when commissions and interest on the loans are factored in, he winds up in the red.
What's more, if our investor had only executed the second losing transaction, he could have triggered a margin call, forcing him to sell other investments to meet maintenance minimums. The takeaway here is that margin accounts are risky. They should be used in moderation, for limited positions, and for short time periods only — because even the pros are not good at guessing the market over time. Once you begin to accumulate some marginable securities in your margin account, you can leverage those assets for additional margin loans.
Instead of adding more cash to the pile, you can use the value of those stocks as collateral to purchase additional shares on margin. That could potentially result in a higher ratio of returns to initial investment. Say you invest on margin, and you use borrowed funds to buy shares of stock instead.
A lower initial cash investment also gives you the flexibility to diversify into other investments in your trading account, and increased diversification may help provide insulation against risk. The risks and drawbacks should be carefully considered before trading on margin. Worst-case scenario? Your brokerage may sell all of your shares to fulfill a margin call, meaning a total loss of your initial investment.
If this happens, you might need to deposit more money into your account. A margin call i. Brokerages typically require a baseline of 25 percent the industry requirement for a long margin account , meaning you must have at least 25 percent equity of the total market value of the securities in your account. Ally Invest has a minimum maintenance level of 30 percent, but some firms have a threshold as high as 40 percent.
The possibility of losing money quickly as a result of a margin call makes margin trading something to consider carefully. The loan in the account is collateralized by the securities purchased and cash, and comes with a periodic interest rate. Because the customer is investing with borrowed money, the customer is using leverage which will magnify profits and losses for the customer. If an investor purchases securities with margin funds, and those securities appreciate in value beyond the interest rate charged on the funds, the investor will earn a better total return than if they had only purchased securities with their own cash.
This is the advantage of using margin funds. If the securities decline in value, the investor will be underwater and will have to pay interest to the broker on top of that.
The investor has the potential to lose more money than the funds deposited in the account. For these reasons, a margin account is only suitable for a sophisticated investor with a thorough understanding of the additional investment risks and requirements of trading with margin. A margin account may not be used for buying stocks on margin in an individual retirement account , a trust or other fiduciary accounts.
Financial products, other than stocks, can be purchased on margin. Futures traders also frequently use margin, for example. With other financial products, the initial margin and maintenance margin will vary.
Exchanges or other regulatory bodies set the minimum margin requirements, although certain brokers may increase these margin requirements. That means margin may vary by broker. The initial margin required on futures in typically much lower than for stocks. Margin accounts are required for most options trading strategies as well. By taking double the position the potential profit was doubled. The customer has lost their funds and can no longer maintain the position.
This is a margin call. A margin account is a brokerage account which allows you to borrow money against the investments in your account. As the buyer, you pay a portion of the purchase price and the broker lends you the difference. Any income or interest earned in your account may be used to help offset the cost of borrowing.
The portion of the purchase price that you pay depends on the security. To learn more, see Eligible Securities and Applicable Margin. The outstanding loan value is initially determined using the purchase price of the security. However, from that point on, the outstanding loan value is generally based on the market. This means that every day, as the value of your holdings and cash balance change in your margin account, the amount you are able to borrow against them will vary.
In a favourable bull market, this can be an effective strategy—but it can work against you in an unfavourable bear market.
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