Buying power

What Is Buying Power?

Buying power, within the realm of investment concepts and financial markets, refers to the total amount of money an investor has available to purchase securities at any given time. This amount is not solely limited to the cash held in a brokerage firm account. Instead, it typically includes the available cash balance plus any funds that can be borrowed on margin. Essentially, buying power determines the maximum value of assets an investor can acquire. It is a dynamic figure that fluctuates with market values, deposits, withdrawals, and changes in regulatory or firm-specific margin account requirements.

History and Origin

The concept of buying power, particularly as it relates to borrowed funds, is deeply intertwined with the history of margin trading. The ability to purchase securities with borrowed money has existed for many decades, but its regulation became formalized in the United States with the Securities Exchange Act of 1934. This legislation empowered the Federal Reserve Board to set rules governing the extension of credit by brokers and dealers for the purchase of securities. This led to the creation of Regulation T, which outlines the initial amount of cash an investor must deposit when buying securities on margin. Regulation T, established in 1934, significantly impacted how brokerage firms could extend credit, thereby directly influencing investors' buying power.²⁰, ²¹ The primary purpose of such regulations was to curb excessive speculation and mitigate systemic risk in the financial system by controlling the amount of leverage available to investors.

Key Takeaways

• Buying power represents the total capital available to an investor for purchasing securities, including both cash and borrowable funds.
• It is significantly influenced by margin rules set by regulatory bodies like the Federal Reserve Board (Regulation T) and the Financial Industry Regulatory Authority (FINRA).
• Utilizing buying power through margin can amplify both potential gains and losses.
• Fluctuations in asset values or changes in margin requirements can lead to a margin call, requiring additional funds.
• Beyond financial markets, buying power also refers to the economic ability of consumers to purchase goods and services, often impacted by inflation.

Formula and Calculation

In a margin account, an investor's buying power is typically calculated based on the available cash and the amount of credit extended by the brokerage firm. The standard formula for buying power in a typical margin account is often:

Alternatively, if considering the funds available for new purchases based on an existing account with equity:

Where:

• Cash Available: The uninvested cash in the margin account.
• Market Value of Marginable Securities: The current total value of securities that qualify for margin lending.
• Maintenance Margin Percentage: The minimum percentage of equity required to be maintained in the account, typically 25% by FINRA rules, though brokerage firms often have higher "house" requirements (e.g., 30-40%).¹⁷, ¹⁸, ¹⁹
• Marginable Equity: The total equity in the margin account that can be used to borrow against.
• Leverage Ratio: This depends on the initial margin requirement. If the initial margin is 50% (as per Regulation T for most stocks), the leverage ratio is 2 (meaning for every $1 of equity, you can control $2 worth of securities).¹⁶

Interpreting Buying Power

Interpreting buying power involves understanding both its potential and its associated risk management implications. A high buying power allows an investor to control a larger value of securities than their cash balance alone would permit, amplifying potential returns from favorable market movements. However, this also magnifies potential losses if the market moves unfavorably. For example, a buying power of 2:1 means that for every dollar of available equity, an investor can purchase two dollars' worth of securities.

Beyond financial trading, buying power also refers to the general economic capacity of consumers to purchase goods and services. This broader interpretation of buying power is directly affected by economic factors such as inflation. When inflation rises, the same amount of money buys fewer goods, effectively reducing consumer buying power.¹⁴, ¹⁵

Hypothetical Example

Consider an investor, Sarah, who has a margin account with $10,000 in cash and $20,000 worth of marginable securities. Her brokerage firm has an initial margin requirement of 50% and a maintenance margin of 30%.

1. Calculate Initial Buying Power (based on available cash for new purchases):
   With $10,000 cash, and an initial margin of 50%, Sarah can purchase $10,000 / 0.50 = $20,000 worth of new securities. This means she uses her $10,000 cash and borrows an additional $10,000 from the brokerage firm.

2. Calculate Total Buying Power (considering existing portfolio for additional borrowing):
   Her total equity in the account is $10,000 (cash) + $20,000 (securities) = $30,000.
   Assuming the $20,000 in securities were purchased without margin, the maximum she can borrow against them is typically 50% of their market value. However, the calculation of buying power often considers the available cash plus the potential new leverage on her existing marginable equity. If she has $10,000 cash and $20,000 in securities already, her available margin for new purchases would be determined by her excess equity.

   Let's assume her current account value is $30,000 (all marginable).
   Required maintenance margin (30% of $30,000) = $9,000.
   If her current loan is $0, her excess equity is $30,000 - $9,000 = $21,000.
   With a 2x leverage (from 50% initial margin), her total buying power for new purchases could be $21,000 * 2 = $42,000.

This illustrates that buying power allows Sarah to acquire significantly more securities than her cash balance alone would permit.

Practical Applications

Buying power is a fundamental concept across several areas of finance:

• Stock Trading: The most common application is in allowing investors to purchase more securities than their cash balance permits by using a margin account. This amplifies the potential returns but also the risks.¹³
• Day Trading: Day trading strategies heavily rely on maximizing buying power to execute numerous trades within a single day. Pattern day trading rules require a minimum equity of $25,000 and typically cap purchasing power at four times the maintenance margin excess from the previous day's close.¹²
• Economic Analysis: Economists and policymakers assess aggregate consumer buying power as a key indicator of economic health. Factors like wage growth, employment levels, and inflation directly influence how much individuals can purchase. When real disposable income increases, it provides consumers with greater buying power.¹¹
• Investment Strategy: Understanding one's buying power is crucial for effective portfolio management and strategic asset allocation. It allows investors to assess their capacity to respond to market opportunities or manage unexpected margin calls.

Limitations and Criticisms

While increased buying power through leverage can enhance potential returns, it comes with significant limitations and criticisms, primarily centered on increased risk management challenges:

• Magnified Losses: The most significant drawback is that losses are amplified proportionally to the leverage used. An unfavorable price movement in a security purchased on margin can quickly deplete an investor's equity and lead to losses exceeding the initial investment.⁹, ¹⁰
• Margin Calls: If the value of the collateral in a margin account falls below the maintenance margin requirement, the investor faces a margin call. This necessitates depositing additional funds or liquidating positions, often at a loss, to meet the requirement.⁸ Brokerage firms can liquidate securities without prior notice if a margin call is not met.⁶, ⁷
• Interest Costs: Borrowing funds incurs interest rates on the loan, which can erode profits or exacerbate losses, particularly if the investment does not perform as expected.⁵
• Market Volatility: In periods of high market volatility, margin accounts become riskier as rapid price swings can trigger frequent margin calls and forced liquidations. The U.S. Securities and Exchange Commission (SEC) warns that margin accounts "can be very risky and they are not suitable for everyone."⁴ More information about the risks involved is available from FINRA.³

Buying Power vs. Margin

While closely related, "buying power" and "margin" refer to distinct but interconnected concepts in finance.

Buying power is the total capacity an investor has to execute trades. It represents the maximum dollar amount of securities that can be purchased. This calculation includes both the investor's available cash and any funds they can borrow from their brokerage firm using margin.

Margin, on the other hand, is the portion of an investment that is borrowed from a brokerage firm to purchase securities. It is essentially a loan, with the purchased securities serving as collateral. When an investor buys on margin, they are using leverage to increase their exposure to the market.

In summary, margin is the tool (the loan) that expands an investor's buying power beyond their immediate cash holdings. Buying power is the result or the capability that arises from using cash and/or margin credit.

FAQs

What factors can increase an investor's buying power?

An investor's buying power can increase by depositing more cash into their brokerage firm account, increasing the value of existing marginable securities, or if the brokerage firm or regulators reduce initial margin or maintenance margin requirements.

Can buying power be negative?

No, buying power itself cannot be negative in the sense of a purchasing capability. However, if an account's equity falls below the maintenance margin due to market losses, it can result in a margin call, indicating a deficit that needs to be covered, effectively reducing the available buying power to zero or requiring immediate action to prevent liquidation.

How does inflation affect consumer buying power?

Inflation directly reduces consumer buying power. As prices for goods and services rise, each unit of currency (e.g., a dollar) can purchase fewer items. This means consumers need more money to maintain the same standard of living, and their savings effectively lose value over time if not invested to outpace inflation.¹, ²

Is buying power the same in a cash account as in a margin account?

No, buying power differs significantly between a cash account and a margin account. In a cash account, buying power is limited to the unsettled cash available in the account. In a margin account, buying power includes the cash balance plus the funds that can be borrowed on margin, thus providing greater leverage.