What is Buying on Margin?

Buying on margin is like talking into a microphone…

By speaking into the microphone, your voice is amplified through a speaker. Even if you speak quietly, your voice is bigger than before. And, if you turn up the volume (increase the margin), your message gets even louder (the amount of securities you can buy gets larger). Of course, anything you say that turns out to be embarrassing is also amplified (margin investing can also amplify your losses if shares bought on margin decrease in value).

Buying on margin begins with you opening a margin account with a broker. Such an account is similar to a cash account, except that a margin account allows you to purchase assets beyond your cash account balance. The margin account also has its own set of rules, including being potentially subject to a margin call.

When you want to make a new purchase, you make a deposit of at least $2,000, or whatever higher minimum amount the broker may require. If you qualify as a “pattern day trader,” the minimum equity value that must be maintained in your portfolio by the end of the trading day is $25,000. (You may be deemed a pattern day trader if you conduct four or more day trades from your margin account within a five business day period.)

Once your brokerage account is open, you can begin purchasing and selling securities – just like with a cash account. If your initial deposit was $5,000, then your first $5,000 of purchases would be made with your cash balance. However, the account may give you access to another $5,000 of credit as a margin loan, depending on what you are buying.

If you want to buy more than your $5,000 worth of securities, you can do so by margin trading. However, any money you borrow might be charged a predetermined interest rate. And all of the marginable assets in your account act as collateral against the money you borrow. Whenever you sell stocks, the proceeds go toward repaying your margin first. If your assets lose too much value, you may be issued a margin call and would need to either deposit more money or sell some assets to bring your portfolio value above the margin maintenance requirement. If you do not act quickly enough, your broker will sell your assets for you.

Not all securities are allowed to be purchased on margin. And there are limits to how much margin you can have. The Federal Reserve Board (FRB) and the Financial Industry Regulatory Authority (FINRA) regulate margin offered by broker-dealers.

FRB Regulation T limits the amount of borrowed money that can be used to purchase most stocks at 50%. This rule means that a broker can only lend you as much as you deposit, doubling your buying power. FINRA sets further limits on required equity, called maintenance margin. The amount of equity you must maintain is generally 25% of the current market value of the securities in your account. However, there are lower maintenance margin requirements on less risky assets, like long-term government bonds.

The FRB also determines which products are marginable securities. The general rule is that any stock listed on an exchange for more than six months is eligible (no IPOs). Some over-the-counter (OTC) securities are allowed, but only if they are on the authorized list — Which excludes stocks trading below $5 per share and has several other limitations.

The best way to understand the risks and benefits is to walk through the math. Let’s take this example:

Imagine you open a margin account with a $5,000 opening deposit. After thorough research, you are convinced that the stock of a certain company is about to breakout. So you purchase $10,000 worth of stock in this company ($5,000 of your money and $5,000 of borrowed money). At a purchase price of $50 per share, you are able to buy 200 shares.

First, let’s assume you were correct. The stock did breakout and ran up from $50 a share to $70 a share. Had you only used your own money, you could have purchased only 100 shares. Doing so would have resulted in an unrealized gain of $2,000 (the increase in stock value of 100 shares from $5,000 to $7,000) minus transaction fees.

But by using the margin in your account, you doubled your purchase to 200 shares. As a result, you made another $2,000 in unrealized gains off the borrowed money. In this case, when you sell your 200 shares at $70 apiece, you collect $14,000 of market value. You repay the margin of $5,000 that you borrowed, plus $100 in interest charges, leaving you with $8,900 (assuming no additional transaction fees).

Of that, $5,000 was money you already had when you opened the account. The other $3,900 is profit. That works out to a 78% return on investment ($3,900 / $5,000), even though the stock increased in value by only 40% ( ($70-$50) / $50).

Now, look at what happens if you are wrong. Rather than breaking out to the upside, the stock falls down to $33 per share. If you had used only your own money, you would suffer a loss of $1,700 (a loss of $17 per share on 100 shares). But, by using margin, you ended up buying 200 shares. When the stock price falls to $33 per share, your account balance drops to $6,600 ($33 per share x 200 shares). At that point, your equity in the account is only $1,600 and the other $5,000 belongs to the broker. Because $1,600 out of $6,600 in only 24%, your equity is below the margin maintenance requirement of 25%. Therefore, the brokerage firm issues a margin call.

At this point you have a couple options.

First, you could add some additional funds to your account to meet the minimum account requirement of 25%.To prevent the the brokerage firm from issuing a margin call, you would need to add at least $50 to your account ($6,600 * 25% = $1,650). This scenario assumes that you plan on holding to your position.

Second, you could sell some or all of your position. Let’s assume that you plan to sell your entire position of $6,600. You first repay the $5,000 you borrowed, plus any interest. Let’s assume that you held on to your shares for 100 days like in the example above, so the total interest is $146 as well. Assuming no other transaction costs, that leaves you with up to $1,600 of your initial investment. In other words, you suffered a 71% loss (-$3,546 / $5,000) because the stock price fell by 34% ( ($50 - $33) / $50).

The practice of buying on margin rose to prominence in the 1920s. During that time, the U.S. stock market was really beginning to take off. Many people were seeing significant gains, and many more wanted to get on board that train. But, without much money in the bank, taking advantage of the bull market was difficult.

Margin accounts were not well regulated at the time. Lenders regularly lent money on 90% margins. With that much leverage, a person was able to amplify their earning power 10-fold. Unfortunately, their risk exposure was equally high. The losses from buying on margin is sometimes cited as one of the factors that contributed to the Great Depression. It has since become far more regulated and restricted.

Buying on margin and short selling are similar in that they both utilize borrowing to make trades. However, they are different in application. When you buy on margin, you borrow money from your broker to purchase assets. Most often, these are assets you expect to increase in value. You then aim to repay the broker with the proceeds from the asset sale.

Short selling is a little different. When you short a stock, you are effectively borrowing shares from the owner of the stock and selling them. You replace that owner’s shares when you repurchase the same stock in the future. The goal is to purchase the replacement shares at a lower price than you received when you sold them.

So, buying on margin is borrowing money to make purchases, using the assets as collateral, then repaying the money plus any interest. Short selling is borrowing and then selling a stock, using a portion of the cash proceeds as collateral, then replacing that same stock — hopefully at a lower price. There is also unlimited risk to the upside when selling short.

Generally, investors with adequate resources and credit can buy on margin if they meet certain requirements set by each broker dealer. But typically only someone with a higher tolerance of risk should engage in the practice. Trading stocks is a risky business with a lot of potential rewards. Buying on margin amplifies the potential rewards but also the risks.

Additional disclosures:

Any examples provided are hypothetical and do not reflect actual or anticipated results, and are used for illustrative purposes only. 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. The brokerage firm 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, Your brokerage firm 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.