What is Margin?
Buying on margin means borrowing money from your broker to buy securities — Margin is the difference between the value of the investment and the amount you borrowed.
Margin can refer to many things in the world of finance. When it comes to investing, buying on margin involves borrowing money from your broker to buy securities, such as stocks or bonds. Margin is the difference between the total value of the investment and the amount you borrow from a broker. Basically, you’re using cash or securities you already own as collateral to buy more in hopes of making a profit. As with other loans, you have to pay back the money you borrowed plus interest, though there’s usually no set schedule for repaying the principal. But margin trading comes with risks. If the amount you borrowed gets too high relative to the value of your securities, you will have to deposit more funds, or your broker can sell off some of your assets. Even if you lose your entire investment, you still have to pay back what you borrowed with interest.
Let’s say you want to buy $10,000 worth of stock, and your broker has a 75% initial margin requirement (the part of the purchase you must fund). That means you need to pay $7,500 and can borrow $2,500 to buy the shares. As long as you keep the stock without paying back the money, you will owe interest on the borrowed amount. If you had paid the full $10,000 instead of buying on margin, you would have tied up the entire amount waiting for the stock price to hopefully increase. By buying on margin, you free up $2,500 for other investments. However, you still have to pay interest and possibly fees, and there’s always a risk the stock price will go down.
Margin is like a helping hand from your parents...
Sometimes you need a little extra cash. Perhaps you can afford the rent, but not the security deposit, on a new apartment. Your parents might loan you money for the deposit and ask that you return it when you move out, provided you don’t damage the place. Margin is similar: Your broker loans you part of the funds needed to buy stock, and you don’t have to pay him back right away. Instead, he only charges interest while you own the stock, and you pay him back after selling it. But things get a little more complicated if the stock price falls significantly.
Buying on margin involves using a combination of your cash or other assets and borrowed funds from your broker to buy securities like stocks and bonds. For example, you may pay 60% of the cost, and your broker may loan you the other 40% to make a purchase. You pay interest on the amount you borrowed. When you sell the securities, you pay back the loan. If the assets have gone up in value, you make a profit. If not, you may lose money on the investment, and you still have to pay back what you borrowed.
The first step is to find a brokerage that offers accounts that allow you to buy on margin. When you apply for a margin account, the broker may consider your income, net worth, credit history, and other factors when deciding whether to issue approval. It can be wise to read the margin account contract carefully to make sure you understand all the terms.
Once the broker has approved your margin account, you’ll need to deposit funds. The Federal Reserve Board, which governs the U.S. central banking system, requires a minimum 50% initial margin (meaning you can fund half of the purchase price and borrow half), but brokerages can choose to require more.
The Financial Industry Regulatory Authority (FINRA), a government-authorized regulator of brokerage firms, mandates that investors deposit at least $2,000 before trading on margin, but your broker can require a higher amount. You also need enough cash to cover your share of the purchase.
FINRA also requires you to keep at least 25% equity in your account with the brokerage, known as the maintenance margin. You can calculate this by taking the value of securities you own and subtracting the amount you owe to the broker. Your brokerage may require a higher maintenance margin than FINRA does. If you fall below this floor, you can’t continue buying on margin. You may also have to repay the amount borrowed quickly if the value of the security purchased on margin, or of your entire portfolio of assets, drops. If this happens, you may be subject to a margin call.
A margin call happens when you fall below the required maintenance margin. In other words, you owe the broker more than brokerage and FINRA rules allow relative to the value of your stocks or bonds. A margin call is when the broker contacts you and asks you to deposit funds to bring the account up to the margin maintenance minimum. If you can’t deposit the funds quickly, the broker may sell some of your securities. Note that your broker doesn’t necessarily have to tell you before he starts selling your assets; your margin agreement (the contract for the account) spells out his obligations.
People choose to buy on margin to own more of a security than they could otherwise. One reason to do this is to buy stock you believe is an excellent long-term investment but typically trades at a higher price than you can afford. You could borrow to cover the cost until you’re able to pay the money back, assuming you believe your gains will outweigh interest and other costs of buying on margin.
Another reason is that you might believe the price of a security will jump in the near future, and you want to buy more of it in order to sell it quickly at a profit. However, buying on margin, like investing in general, does not mean a guaranteed gain and carries significant risks.
Buying on margin can be a good idea for some investors, but not others. Your personal tolerance for risk, your ability to withstand losses, and your level of understanding about how margin works all play a role in whether this strategy is right for you.
When buying on margin goes well, you might make a profit while investing less money. But risks can be significant. If your securities lose value, you not only lose money on the investment but still have to pay back the money borrowed with interest. You also run the risk of a margin call, which requires you to pay funds back quickly or have your securities sold off to cover the debt. Even if your investments don’t drop in value, you still have to pay interest for borrowing funds, which you wouldn’t have to do if you only invested money you had.
Short selling stocks and margin trading are both investment strategies that involve some borrowing, but they’re not the same. While margin trading involves using borrowed money to buy securities such as stocks, short selling involves selling borrowed stocks or commodities (raw materials or crops, such as silver or corn).
Here’s how short selling works: You borrow shares from a broker, sell them on the market, and then return an equal number of shares to the broker at some point in the future. Investors often short sell when they expect a stock to fall hard in a short time. The hope is to sell the borrowed stock at a high price, then buy the same number of shares later at a much lower cost to return to the broker.
On October 24, 1929, often called Black Thursday, the stock market started falling after a period of rapid growth. More losses followed the next Monday (Black Monday) and Tuesday (Black Tuesday) and continued until 1932, when the Dow Jones Industrial Average fell to a rock bottom of 41.2 points (down from a peak 381.17 in Sept. 1929).
Many factors led up to the crash, but what got many ordinary Americans into trouble as the Great Depression began was margin. The stock market had been so profitable that many people with limited funds wanted in on the action and bought on margin. At the time, federal rules allowed them to borrow up to 90% of the stock value. When the market crashed, many investors couldn’t afford the margin calls and lost everything, leaving them with no safety net to weather the effects of the collapse. Many large investors were caught up in margin as well and ended up too overextended to cover their margin calls.
In regular conversation, margin usually means a difference between the two items. The term comes up a lot in finance. Here are two of the most common uses:
Corporate Accounting In corporate accounting, margin usually refers to gross profit margin, which is the difference between sales and the cost of goods sold (the direct expenses of making the company’s products, including materials and labor). Sometimes called the gross margin ratio, this is often shown as a percentage of sales. Margin can also refer to operating profit margin, which tells you a company’s return on sales.
Mortgage Lending In mortgage lending, margin is part of calculating adjustable mortgage rates. The lender starts with a base rate tied to an index, like the Treasury Index (an index based on U.S. Treasury bill auction rates), then adds a margin to come up with the actual interest rate it will charge. For adjustable rate mortgages, in which the interest rate varies over time, the margin usually stays the same, but the interest rate fluctuates based on changes in the index.
Additional Disclosure: Margin borrowing increases your level of market risk, as a result it has the potential to magnify both your gains and losses.
Regardless of the underlying value of the securities you purchased, you must repay your margin loan.
Robinhood Financial can change their maintenance margin requirements at any time without prior notice.
If the equity in your account falls below the minimum maintenance requirements (varies according to the security), you’ll have to deposit additional cash or acceptable collateral.
If you fail to meet your minimums, Robinhood Financial may be forced to sell some or all of your securities, with or without your prior approval. For more information please see Robinhood Financial’s Margin Disclosure Statement, Margin Agreement and FINRA Investor Information.
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