Buying on margin

What Is Buying on Margin?

Buying on margin refers to the practice of purchasing financial assets, such as stocks, using borrowed money from a brokerage firm. This falls under the broader category of securities trading and is facilitated through a specialized brokerage account known as a margin account. When an investor buys on margin, they are essentially taking out a loan from their broker, with the purchased securities serving as collateral for that loan. This strategy can amplify returns, but it also significantly increases risk. Investors are required to maintain a certain percentage of the investment's value in their account, known as the initial margin, and subsequently, a maintenance margin to cover potential losses. The use of borrowed funds, or leverage, means that both gains and losses are magnified. Given the inherent risks, understanding the potential for amplified losses due to market volatility is crucial before engaging in buying on margin.

History and Origin

The concept of buying on margin has been a feature of financial markets for centuries, but its widespread and unregulated use reached a peak in the 1920s. During this period, investors could purchase stocks by putting down as little as 10% of the purchase price, borrowing the remaining 90% from their brokers. This easy access to credit fueled rampant speculation, with many individuals leveraging their investments in hopes of quick and substantial gains. The excessive use of margin was a significant contributing factor to the dramatic market bubble that preceded the 1929 stock market crash. When stock prices began to fall, brokers issued "margin calls," demanding that investors deposit more funds to cover their loans. Unable to meet these calls, many investors were forced to sell their holdings, exacerbating the market's decline and contributing to the severity of the Great Depression.¹², ¹³

In response to these events, the U.S. Congress passed the Securities Exchange Act of 1934, which established the Securities and Exchange Commission (SEC) and granted the Federal Reserve System the authority to set margin requirements.¹¹ This legislation aimed to prevent a recurrence of the speculative excesses that contributed to the 1929 crash by regulating the extension of credit in securities trading. The Federal Reserve, under its Regulation T, now dictates the maximum percentage of the purchase price that can be borrowed for most securities, typically set at 50%.¹⁰

Key Takeaways

• Amplified Returns and Losses: Buying on margin allows investors to control a larger position with less capital, magnifying both potential gains and losses.
• Borrowed Funds and Collateral: Investors borrow money from their brokerage, using the purchased securities as collateral for the loan.
• Margin Requirements: Investors must meet initial margin requirements to open a position and maintenance margin requirements to keep it open.
• Risk of Margin Calls: If the value of the securities falls below the maintenance margin, a margin call is issued, requiring additional funds or leading to forced selling.
• Interest Expenses: Investors incur interest charges on the borrowed funds, which can erode profits or deepen losses.

Formula and Calculation

The primary calculations involved in buying on margin relate to the account's equity and margin requirements.

The equity in a margin account is calculated as:

The maintenance margin percentage is the minimum percentage of the total market value of the securities that an investor's equity must represent. If the equity percentage falls below this level, a margin call is triggered.

The formula to determine the stock price at which a margin call will occur for a long position is:

For example, if an investor buys 100 shares at $50 each on margin with an initial margin of 50%, they borrow $2,500. If the maintenance margin is 25%, a margin call will be triggered if the stock price falls to a level where the equity is less than 25% of the market value.

Interpreting Buying on Margin

Buying on margin is fundamentally a strategy of using leverage. When an investor interprets the decision to buy on margin, they must weigh the potential for increased returns against the significantly amplified risks. A rising market can lead to substantial profits, as the gains on the full value of the securities are realized with only a fraction of the investor's own capital. However, a falling market can lead to rapid and significant losses that may exceed the initial investment, potentially resulting in a margin call where the investor must deposit additional funds or face forced liquidation.

Effective risk management is paramount when interpreting the implications of margin use. Market volatility can quickly erode account equity, making careful monitoring of positions essential. Investors should consider their risk tolerance and financial capacity to meet potential margin calls before employing this strategy.

Hypothetical Example

Consider an investor, Sarah, who has $10,000 to invest.

• Scenario 1: No Margin (Cash Account)

  • Sarah buys 100 shares of Company X at $100 per share, totaling $10,000.
  • If Company X's stock price increases to $120 per share, Sarah's investment is now worth $12,000.
  • Her profit is $2,000 ($12,000 - $10,000), a 20% return on her $10,000 investment.
  • If Company X's stock price decreases to $80 per share, her investment is worth $8,000.
  • Her loss is $2,000, a 20% loss.

• Scenario 2: Buying on Margin

  • Sarah uses her $10,000 as initial margin (assuming a 50% initial margin requirement). This allows her to buy $20,000 worth of stock.
  • She buys 200 shares of Company X at $100 per share, totaling $20,000, borrowing $10,000 from her broker.
  • If Company X's stock price increases to $120 per share, her investment is now worth $24,000.
  • After repaying the $10,000 loan, her equity is $14,000.
  • Her profit is $4,000 ($14,000 - $10,000 initial capital), a 40% return on her $10,000 capital, excluding interest rate charges.
  • If Company X's stock price decreases to $80 per share, her investment is worth $16,000.
  • After repaying the $10,000 loan, her equity is $6,000.
  • Her loss is $4,000, a 40% loss on her $10,000 capital.
  • If the price continues to drop and her equity falls below the maintenance margin (e.g., 25%), a margin call would be issued, potentially leading to the liquidation of her position if she cannot deposit more funds.

This example illustrates how buying on margin amplifies both gains and losses.

Practical Applications

Buying on margin is primarily used by investors and traders seeking to amplify their returns or execute specific trading strategies. Its practical applications include:

• Increased Purchasing Power: Margin allows investors to purchase more securities than they could with just their available cash, potentially increasing profit opportunities in a rising market.
• Short Selling: While "buying" on margin, the concept of a margin account is fundamental to short selling, where an investor borrows securities to sell them, hoping to buy them back later at a lower price. This also involves specific margin requirements.
• Day Trading and Active Trading: Active traders often use margin to increase their trading capital and execute numerous trades within a short period, although specific rules and higher minimum equity requirements apply to pattern day traders.⁹
• Arbitrage Strategies: Certain arbitrage strategies that involve simultaneous buying and selling of related assets may utilize margin to capitalize on small price discrepancies.
• Portfolio Management: Some institutional investors or sophisticated individual investors might use margin strategically within a broader portfolio to rebalance or temporarily increase exposure to certain assets, though typically with strict risk management protocols. While margin debt can signal investor confidence, rapid surges in margin debt can also be viewed as a potential warning sign of excessive speculation in the market.⁶, ⁷, ⁸

Limitations and Criticisms

Despite its potential for amplified gains, buying on margin carries significant limitations and criticisms:

• Amplified Losses: The most critical drawback is that losses are magnified just as much as gains. A relatively small percentage decline in the value of the margined securities can lead to a substantial percentage loss of the investor's capital, potentially exceeding the initial investment.
• Margin Calls: If the value of the securities falls, the investor may receive a margin call, requiring them to deposit additional funds immediately to bring their account equity back up to the maintenance margin level. Failure to meet a margin call can result in the broker forcibly selling the securities in the account, often at unfavorable prices, to cover the loan.⁵ This forced liquidation can lock in substantial losses.
• Interest Expenses: Investors must pay interest rate on the borrowed funds, which adds to the overall cost of the investment and can erode profits, especially if the investment does not perform as expected or if held for a long period.
• Increased Stress and Risk: The heightened risk associated with buying on margin can lead to significant psychological stress for investors, particularly during periods of high market volatility. It runs counter to strategies like diversification, which aim to reduce risk.
• Regulatory Oversight and Systemic Risk: While regulations such as those by the Federal Reserve and FINRA (e.g., FINRA Rule 4210) are in place to mitigate systemic risk, widespread margin usage still poses a risk to market stability during sharp downturns, as it can accelerate selling pressure.³, ⁴ Historically, the loose margin requirements contributed to the severity of the 1929 market crash, highlighting the systemic danger when margin is overused without adequate safeguards.² Regulators aim to prevent such scenarios by imposing rules, but extreme market events can still challenge these safeguards.¹

Prudent investors often use stop-loss orders and other risk management techniques when buying on margin to limit potential losses.

Buying on Margin vs. Cash Account

The fundamental difference between buying on margin and using a cash account lies in the source of funds for purchasing securities.

While buying on margin offers the opportunity for greater returns, it introduces the significant risk of magnified losses and the potential for margin calls. A cash account, conversely, limits an investor's exposure to only the capital they have, making it a lower-risk option.

FAQs

What is a margin account?

A margin account is a specialized brokerage account that allows an investor to borrow money from their broker to buy securities. The securities purchased serve as collateral for the loan, and the account is subject to specific rules regarding the amount of equity an investor must maintain.

How does buying on margin work?

When an investor buys on margin, they deposit a percentage of the total purchase price, known as the initial margin, and borrow the rest from the brokerage. If the value of the securities declines, and the account's equity falls below a predetermined level (the maintenance margin), the investor may face a margin call, requiring them to deposit more funds or sell some assets.

What are the main risks of buying on margin?

The primary risks include magnified losses, the potential for margin calls that force the sale of securities at unfavorable prices, and the cost of interest on the borrowed funds. Buying on margin significantly increases an investor's overall risk management challenge, as market downturns can rapidly erode capital.