What is Buying on Margin?

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Definition:

Buying on margin refers to the practice of borrowing money to buy securities.

🤔 Understanding buying on margin

The practice of buying on margin means that an investor can borrow money to expand their portfolio. The investor is required to contribute a certain percentage of the investment and may borrow the rest of the money to complete a transaction. In stocks, at least 50% of the money must come from the investor to comply with the Federal Reserve Board requirements. The investor is also required to maintain a certain amount of equity in a margin account thereafter under FINRA requirements. Buying on margin amplifies the gains and losses an investor makes by earning or losing money on securities purchased with borrowed money as well as their own. The practice comes with higher risk and greater potential reward than directly purchasing securities with only your own money.

Example

Let’s say you think that gold prices are about to increase. You are very confident and are disappointed that you only have $20,000 to invest. So, you call your broker and open a margin account. With your $20,000 in deposits, the broker allows you to purchase up to $40,000 worth of stock in companies that extract gold. If you turn out to be correct, you will realize greater investment gains than you could have alone. But, if you turn out to be wrong, your losses also increase.

Takeaway

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.

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How does buying on margin work?

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 have. If you qualify as a “pattern day trader,” the initial margin 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 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 will need to either deposit more money or sell some assets to pay off the loan. If you do not act quickly enough, your broker will sell your assets for you.

What are the rules for buying on margin?

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 your account value. 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.

What are the risks and benefits of buying on margin?

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.

Success Case

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 a 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 gross proceeds 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).

Cash OnlyOn Margin
Shares Purchased100200
Change in Share Price$20$20
Net Proceeds$2,000$4,000
Interest0-$100
Profits$2,000$3,900

Loss Case

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 requirement of 25%. Therefore, the brokerage firm issues a margin call.

When your shares are sold, you collect $6,600. You first repay the $5,000 you borrowed, plus any interest. Assuming no other transaction costs, that leaves you with up to $1,600 of your initial investment. In other words, you suffered a 68% loss (-$3,400 / $5,000) because the stock price fell by 34% ( ($50 - $33) / $50).

Cash OnlyOn Margin
Shares Purchased100200
Change in Share Price-$17-$17
Net Proceeds-$1,700-$3,400
Interest0?
Profits-$1,700-$3,400 + interest

What is the history of buying on margin?

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.

How is buying on margin different than short selling?

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 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 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.

Who should buy on margin?

Anyone with adequate resources and credit can buy on margin. But 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:

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.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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