What Is the Definition of Buying on Margin?
Uncover the full meaning of buying on margin, a financial strategy that amplifies investment potential and risk. Understand its mechanics and implications.
Buying on margin allows investors to amplify their potential returns by borrowing funds to purchase securities. This strategy involves a loan from a brokerage firm, enabling an investor to control a larger position than their available cash might otherwise permit. While it can enhance gains when investments perform well, it also significantly magnifies losses if the market moves unfavorably. Understanding its mechanics and risks is important for those considering its use.
Understanding Margin Accounts
Buying on margin involves an investor borrowing money from a brokerage firm to acquire financial securities. This arrangement creates a loan where the purchased securities and any other eligible assets in the investor’s account serve as collateral.
Investors pay interest on borrowed funds, which accrues daily and is typically charged monthly. The interest rate varies based on the amount borrowed and prevailing market rates, often fluctuating with the federal funds rate. By controlling a larger position, any percentage increase in the security’s value results in a magnified percentage gain relative to the investor’s initial capital.
Conversely, if the value of the securities declines, losses are also amplified beyond what a cash-only purchase would incur. This leverage means small market movements can substantially impact the investor’s equity. Using a margin account carries increased risk and requires careful consideration of market volatility and personal risk tolerance.
Essential Margin Terminology
The initial margin refers to the percentage of a security’s purchase price that an investor must pay with their own funds. Federal regulations generally require this to be at least 50% for most equity purchases, though brokerage firms may set higher requirements based on their risk assessments. For example, to purchase $10,000 worth of stock, an investor might need to contribute at least $5,000 from their own capital, with the remaining amount borrowed.
The maintenance margin represents the minimum equity percentage an investor must maintain in their margin account relative to the total market value of the securities. This percentage is set by the brokerage firm, typically ranging from 25% to 30% of the total security value, but can be higher for more volatile securities. If the investor’s equity falls below this level, it triggers a margin call. Equity is calculated as the current market value of the securities minus the amount of the margin loan.
Not all securities are eligible for purchase on margin; only “marginable securities” can be used as collateral for a margin loan. Brokerage firms maintain lists of eligible securities; highly volatile or thinly traded stocks typically do not qualify. The margin call threshold is the price point where the securities’ value declines, causing the investor’s equity to fall below the maintenance margin requirement.
The Margin Call Process
A margin call is triggered when the equity in an investor’s margin account drops below the required maintenance margin level. This usually occurs because the market value of the securities purchased on margin has declined significantly. The brokerage firm will notify the investor, typically through an electronic message, phone call, or written notice, informing them of the deficit and the amount of additional funds or securities required.
Upon receiving a margin call, an investor has options, usually within two to five business days. They can deposit additional cash or fully paid marginable securities into their account to increase equity. The third option is to sell some securities held in the margin account to reduce the outstanding loan balance, thereby increasing the equity percentage.
If an investor fails to meet the margin call within the specified period, the brokerage firm has the right to take action to protect its loan. The broker can sell any or all of the securities in the investor’s account without prior consultation or approval, even if doing so results in a substantial loss for the investor. This liquidation process is designed to bring the account back above the maintenance margin requirement, covering the deficit and any associated fees or accrued interest.