Why Is Buying on Margin Considered Risky?

Buying on margin involves borrowing money from a brokerage firm to purchase securities. While this practice can amplify potential investment gains, it also carries substantial risks. Understanding these risks is important for anyone considering borrowed funds for investment. This article explains why buying on margin is risky.

How Margin Accounts Work

A margin account differs from a standard cash account because it permits an investor to borrow funds from a brokerage. In a cash account, an investor must pay the full purchase price for securities. Conversely, a margin account allows the investor to use existing securities as collateral for a loan, increasing their purchasing power beyond their cash balance.

When opening a margin account, investors face two main requirements: initial margin and maintenance margin. Initial margin, often 50% of the purchase price, is the percentage an investor must pay upfront. For instance, to buy $10,000 worth of stock, an investor might need to provide $5,000. Maintenance margin, typically 25% of the security’s market value, is the minimum equity percentage an investor must maintain. Brokerage firms often set higher maintenance requirements, sometimes 30% to 40%. This borrowing mechanism creates leverage, meaning a small movement in the security’s price can result in a much larger percentage change in the investor’s equity.

The Impact of Market Volatility

Market price fluctuations, particularly downward movements, can amplify losses on margin. Leverage, while offering the potential to magnify gains, equally magnifies losses. If a security purchased with borrowed funds decreases in value, the investor’s equity declines rapidly because the loan amount remains constant.

An investor using 50% initial margin to purchase shares. A modest percentage drop in the stock’s value can lead to a disproportionately larger percentage loss of the investor’s actual capital. This occurs because the investor is responsible for the entire loss in the security’s value, even though they only put up a portion of the initial capital. Rapid market downturns can quickly erode an investor’s equity.

As margined securities fall, the investor’s equity percentage decreases. This pushes the account balance closer to maintenance margin requirements. Leverage means investors can lose more than their initial investment, making market volatility a substantial risk.

Understanding Margin Calls

A margin call is a demand from a brokerage firm for an investor to deposit additional funds or securities. This demand arises when securities in the margin account fall below the maintenance margin level, meaning equity no longer meets the required minimum. The purpose of a margin call is to restore the account’s equity to the maintenance margin requirement.

Upon receiving a margin call, an investor has a limited timeframe, often two to five business days, to meet the requirement. To satisfy the call, the investor can deposit additional cash, transfer marginable securities, or sell existing securities. Not meeting a margin call allows the brokerage to sell the investor’s securities.

Brokerage firms can liquidate positions without prior notice to cover the outstanding loan, even if it results in substantial losses. This forced sale can occur at unfavorable market prices, locking in losses that might have been avoided. If proceeds are insufficient to cover the loan and any associated fees, the investor remains responsible for the deficit, leading to a negative account balance.

Interest on Borrowed Funds

Borrowing money from a brokerage to buy securities incurs interest charges, an ongoing cost to the investor. This interest is calculated daily on the borrowed amount and posted to the account monthly. Margin interest rates are variable, often tied to benchmark rates, and can fluctuate and increase over time.

Interest charges mean an investment needs to generate returns sufficient to cover potential losses and the cost of borrowing. This expense can erode potential profits, making it more challenging for the investment to be successful. If an investment underperforms or the margin loan is held for an extended period, accumulating interest can deepen losses, adding financial pressure.