What Is Buying on Margin and How Does It Work?

Buying on margin involves borrowing money from a brokerage firm to purchase securities. This strategy allows investors to amplify potential returns by increasing their purchasing power beyond available cash. While it can magnify gains, it also carries the risk of magnified losses, including the possibility of losing more than the initial investment.

What is a Margin Account

A margin account is a type of brokerage account that enables investors to borrow funds from their broker-dealer to buy securities. This differs from a standard cash account, where an investor is limited to purchasing securities only with funds already present. A cash account operates on a “pay-as-you-go” basis, while a margin account introduces leverage.

To open a margin account, an investor signs a margin agreement with the brokerage firm. Regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), establish minimum equity requirements. FINRA generally requires a minimum deposit of $2,000 or 100% of the purchase price, whichever is less, to utilize margin loans. Some brokerage firms may have higher minimums, particularly for specific trading activities like pattern day trading, which can require $25,000.

The securities purchased within a margin account serve as collateral for the loan extended by the brokerage firm. This allows the investor to control a larger market position than their direct cash investment would permit. However, assets in the account are subject to the margin agreement’s terms, including potential liquidation by the broker under certain circumstances.

How Margin Trading Works

When an investor buys securities on margin, they are taking out a loan from their brokerage firm. The initial amount an investor must contribute from their own capital is known as the initial margin. For most equity securities, the Federal Reserve Board’s Regulation T sets this initial margin requirement at 50% of the purchase price. Brokerage firms can impose higher initial margin requirements based on their risk assessments or for specific securities.

For example, if an investor wishes to purchase $10,000 worth of a stock with a 50% initial margin requirement, they would need to contribute $5,000 of their own funds. The remaining $5,000 would be borrowed from the brokerage firm as a margin loan. This borrowed amount allows the investor to control a $10,000 position with only half the personal capital.

Interest is charged on the borrowed funds, and this rate is variable, fluctuating with market conditions. The interest rate is often tied to the “broker call rate” or “call money rate,” which is the interest rate banks charge brokerage firms for loans. Brokerage firms add their own spread or fee on top of this rate when lending to clients. Interest accrues daily on the outstanding loan balance and is billed to the investor’s account monthly.

Beyond the initial purchase, investors must maintain a certain level of equity in their margin account, referred to as the maintenance margin. FINRA mandates this equity must be at least 25% of the total market value of the securities held. Many brokerage firms set their own “house” maintenance margin requirements, often higher, commonly ranging from 30% to 40% or more, depending on the security and market volatility. This ongoing requirement ensures sufficient collateral to cover the borrowed amount.

Understanding Margin Calls

A margin call is a demand from a brokerage firm for an investor to deposit additional cash or securities into their margin account. This occurs when the account’s equity falls below the maintenance margin requirement. A decrease in the market value of securities held on margin typically triggers the decline in equity.

A margin call calculation involves comparing the current equity percentage in the account to the brokerage’s maintenance margin requirement. If the investor’s equity percentage relative to the total market value of securities drops below this threshold, a margin call is issued. Market volatility can cause rapid price movements, making margin calls more likely during turbulent periods.

Upon receiving a margin call, an investor has several options to satisfy the requirement. These include depositing additional cash into the account or transferring fully paid, marginable securities from another account as extra collateral. Alternatively, the investor can sell some existing securities in the margin account to reduce the outstanding loan balance and bring the equity percentage back above the maintenance level.

Failure to meet a margin call within the specified timeframe, which can be as short as two to five business days, carries significant consequences. Brokerage firms have the right to liquidate any securities in the account, without prior client consent or regard for tax implications, to cover the shortfall. This forced liquidation often occurs at unfavorable market prices, potentially leading to substantial losses, possibly exceeding the initial investment. The investor remains responsible for any deficit even after liquidation, and failure to pay can result in legal action or impact future trading opportunities.