Margin buying

What Is Margin Buying?

Margin buying, a component of the broader financial category of Investment Strategies, refers to the practice of purchasing securities by borrowing money from a brokerage firm. The investor contributes a portion of the purchase price, known as the initial margin, and the brokerage firm lends the remaining balance. The securities purchased serve as collateral for the loan. This leveraged approach allows investors to control a larger position in the market than their direct capital would otherwise permit, potentially amplifying returns. However, it also magnifies potential losses, making margin buying a higher-risk strategy.

History and Origin

The concept of margin buying has been around for well over a century, but its widespread use and subsequent regulation gained prominence in the early 20th century. During the speculative boom of the 1920s, buying stocks "on margin" became a common practice, allowing many ordinary individuals to participate in the booming stock market with only a small down payment. Purchasers typically put down a fraction of the price, often as little as 10%, and borrowed the rest, with the stocks serving as collateral for the loan.¹²,¹¹ This easy access to credit fueled significant speculation and contributed to an "asset bubble."¹⁰

When the stock market crashed in 1929, the prevalent use of margin buying exacerbated the downturn. As stock prices plummeted, brokerage firms issued "margin calls," demanding investors deposit additional funds to cover the diminished value of their collateral. Many investors, unable to meet these calls, were forced to liquidate their holdings, leading to further price declines and a spiraling effect that contributed to the severity of the Great Depression.

In response to this financial crisis, the U.S. government implemented regulations to curb excessive speculation. A key piece of legislation was the Securities Exchange Act of 1934, which granted the Federal Reserve Board (FRB) the authority to regulate the extension of credit for purchasing and carrying securities.⁹ This led to the establishment of Regulation T (Reg T) in 1934, which set initial margin requirements for securities purchases, generally mandating that investors deposit a minimum percentage of the purchase price.⁸, Since 1974, this initial margin requirement for equity securities has been set at 50%.

Key Takeaways

• Margin buying involves borrowing funds from a brokerage to purchase securities, using the purchased securities as collateral.
• It offers the potential to amplify investment returns but also significantly magnifies potential losses.
• Regulation T, established by the Federal Reserve, sets initial margin requirements, currently at 50% for most equity securities.
• Investors using margin accounts are subject to maintenance margin requirements, which dictate the minimum equity level that must be maintained.
• Failure to meet a margin call can result in forced liquidation of securities in the investor's account.

Formula and Calculation

The primary calculation in margin buying relates to the equity in the margin account and the amount of leverage employed.

The equity in a margin account is calculated as:

Where:

• Market Value of Securities is the current market price of the assets held in the margin account.
• Debit Balance is the amount of money borrowed from the brokerage, plus any accrued interest.

The leverage ratio indicates how much of an asset's value is financed by borrowed money and can be expressed as:

For example, if an investor purchases $10,000 worth of stock with $5,000 of their own capital and $5,000 borrowed on margin, their leverage ratio would be ( $10,000 / $5,000 = 2:1 ). This means for every $1 of their own capital, they control $2 worth of assets.

Interpreting Margin Buying

Margin buying is typically interpreted in terms of its impact on potential returns and risks. When an investor engages in margin buying, they are essentially taking on leverage. This leverage means that a small percentage change in the price of the security can lead to a much larger percentage change in the investor's equity.

A rising market can lead to amplified profits for an investor using margin, as the gains apply to the total value of the securities, not just the investor's initial capital. Conversely, a declining market can lead to significantly magnified losses. If the value of the securities falls sufficiently, the investor's equity may drop below the maintenance margin requirement, triggering a margin call. Meeting a margin call requires the investor to deposit additional funds or securities, or the brokerage firm may liquidate assets in the account to bring the equity back to the required level. This forced liquidation can lock in losses and remove the chance for recovery if the market later rebounds.

Hypothetical Example

Consider an investor, Sarah, who wishes to purchase 200 shares of XYZ stock, currently trading at $75 per share. The total value of the purchase would be $15,000.

Assuming an initial margin requirement of 50%:

1. Sarah's Contribution: Sarah must contribute 50% of the $15,000, which is $7,500. This is her equity investment.
2. Borrowed Amount: The brokerage firm lends Sarah the remaining 50%, or $7,500. This is her debit balance.

Now, let's look at two scenarios:

Scenario 1: Stock Price Increases

If XYZ stock rises to $90 per share:

• New Market Value: 200 shares * $90/share = $18,000
• Equity: $18,000 (Market Value) - $7,500 (Debit Balance) = $10,500
• Return on Sarah's Initial Investment: ($10,500 - $7,500) / $7,500 = 40%

Without margin, if Sarah had invested only her $7,500 to buy 100 shares (at $75/share) and the price rose to $90, her return would be (($90 - $75) * 100) / $7,500 = 20%. Margin buying effectively doubled her percentage return.

Scenario 2: Stock Price Decreases

If XYZ stock falls to $60 per share, and the maintenance margin is 25%:

• New Market Value: 200 shares * $60/share = $12,000
• Equity: $12,000 (Market Value) - $7,500 (Debit Balance) = $4,500
• Maintenance Requirement: 25% of $12,000 = $3,000

In this case, Sarah's equity of $4,500 is still above the $3,000 maintenance requirement, so no margin call would be issued yet.

However, if the stock fell further to $45 per share:

• New Market Value: 200 shares * $45/share = $9,000
• Equity: $9,000 (Market Value) - $7,500 (Debit Balance) = $1,500
• Maintenance Requirement: 25% of $9,000 = $2,250

Now, Sarah's equity ($1,500) is below the maintenance requirement ($2,250), triggering a margin call for $750 ($2,250 - $1,500). Sarah would need to deposit $750 to bring her equity back up to the maintenance level, or the brokerage could sell some of her shares.

Practical Applications

Margin buying is employed by investors seeking to amplify their market exposure and potential returns in various market scenarios. It is most commonly associated with active trading strategies, where investors aim to profit from short-term price movements.

• Increased Purchasing Power: Margin allows investors to buy more securities than they could with just their available cash, increasing their potential gains if the investment performs well.
• Short Selling: Margin accounts are essential for short selling, a strategy where an investor borrows shares and sells them, hoping to buy them back later at a lower price. The proceeds from the short sale are held in the margin account and serve as collateral.
• Arbitrage Opportunities: Sophisticated investors may use margin to execute arbitrage strategies, taking advantage of small price discrepancies between related securities.
• Hedging: While margin inherently increases risk, it can also be used in certain hedging strategies to offset potential losses in other parts of a portfolio, although this typically involves complex derivatives.

The regulatory framework for margin buying is primarily governed by the Federal Reserve Board's Regulation T, which sets the rules for credit extended by brokers and dealers. Additionally, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have their own rules regarding margin requirements and account management to protect investors and maintain market stability.⁷,⁶ The SEC, for example, has adopted capital, margin, and segregation requirements for certain financial entities to mitigate systemic risk.⁵

Limitations and Criticisms

While margin buying can magnify gains, its primary limitation is the magnified risk of losses. If the market value of the securities purchased on margin declines, the investor's percentage loss on their own capital is greater than if they had paid for the securities in full. This accelerated loss can quickly lead to a margin call, which forces the investor to either deposit more funds or face the forced liquidation of their holdings.⁴ This can be particularly problematic during periods of high market volatility.

Academic research has explored the impact of margin trading on investor returns and market stability. A study using data from a Chinese brokerage found that, on average, higher risk due to leverage does not translate into higher returns and that leverage tends to reduce investors' returns, primarily through the mechanism of margin calls and forced liquidations.³ The study noted that even for investors who successfully used leverage to earn high gross returns, the accompanying high trading costs almost perfectly offset these returns.²

Critics also point to the potential for systemic risk when margin buying is widespread. As seen in the 1929 stock market crash, a cascading effect of margin calls and forced sales can exacerbate market downturns, leading to broader economic instability. Furthermore, the psychological stress associated with high-risk investment strategies like margin trading has been linked to adverse health outcomes.¹

Margin Buying vs. Cash Accounts

The fundamental distinction between margin buying and a cash account lies in the use of borrowed funds. In a cash account, an investor must pay the full purchase price for any securities, meaning no borrowing is involved. This limits the investor's purchasing power to their available cash.

While a cash account offers simplicity and limits losses to the amount invested, margin buying provides the opportunity for greater capital appreciation but introduces the additional complexities and risks associated with borrowing money and managing debt.

FAQs

What is a margin call?

A margin call occurs when the equity in an investor's margin account falls below the brokerage firm's required maintenance margin level. This typically happens when the value of the securities purchased on margin declines significantly. The investor is then required to deposit additional funds or securities to bring the account's equity back up to the required level. If the investor fails to meet the margin call, the brokerage firm has the right to sell some or all of the securities in the account to cover the deficit, often without prior notice.

What are the risks of margin buying?

The primary risk of margin buying is amplified losses. Because you are using borrowed money, a small percentage drop in the value of your investments can result in a much larger percentage loss of your own capital. Other risks include the possibility of a margin call, which can lead to forced liquidation of your holdings at unfavorable prices, and the obligation to pay interest on the borrowed funds, which eats into potential profits.

Who regulates margin buying?

In the United States, margin buying is primarily regulated by the Federal Reserve Board (FRB) through Regulation T. This regulation sets the initial margin requirements for securities purchased through brokers and dealers. Additionally, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) establish and enforce their own rules and requirements related to margin accounts and trading practices.

Can all securities be bought on margin?

No, not all securities can be bought on margin. The Federal Reserve's Regulation T specifies which types of securities are marginable. Generally, common stocks listed on major exchanges are marginable, but certain securities, such as some penny stocks or new issues, may not be eligible for margin buying. Brokerage firms may also have their own internal policies that are more restrictive than regulatory requirements.

How does interest work with margin buying?

When you engage in margin buying, you are essentially taking out a loan from your brokerage firm. Like any loan, this comes with an interest charge. The interest rate on margin loans can vary and is typically tied to a benchmark rate, such as the prime rate, plus a spread set by the brokerage firm. Interest accrues daily on the borrowed amount (the debit balance) and is usually charged to your account monthly. Understanding these loan terms is crucial for managing your margin account effectively.

Is margin buying suitable for all investors?

No, margin buying is generally not suitable for all investors. Due to the magnified risks, it is typically recommended only for experienced investors who have a thorough understanding of the associated risks, can tolerate significant losses, and have a clear risk management strategy in place. Beginners or investors with a low risk tolerance should generally avoid margin buying.