It’s easier than ever to buy securities. During times of volatility in the financial markets, it can be tempting to dive straight in. But sometimes it happens that an investor does not have enough liquidity when a buying opportunity arises.
Margin investing involves borrowing money from a brokerage firm to make investments. Traders exploit this to increase their purchasing power, then repay the borrowed amount at a later date of their choosing. But the practice involves significant risks and large losses can accumulate quickly. This means that inexperienced investors should exercise caution.
What is margin trading?
When you trade on margin, you borrow money to buy more than one security, such as a stock, bond, or exchange-traded fund, betting that its price will rise. The margin loan comes from your brokerage firm and works the same as other lines of credit. This means that you use the securities in your account as collateral and the brokerage firm can sell them if you are unable to meet the terms of the loan.
How to buy on margin
In order to trade on margin, you must first open an account with a brokerage firm. Then, to be eligible for margin loans, you must apply and be approved by the company. The app will typically ask you for job details and financial information, such as your annual income. Once your approval is approved, you can take out a margin loan at any time without having to submit any additional requests.
Federal agencies and regulators have established rules for margin accounts, although brokerage firms may enact more stringent requirements. Some of the minimum requirements include:
- How much can you borrow: Under Regulation T of the US Federal Reserve, brokerage firms can lend you up to 50% of the total purchase price of most equity securities. For example, if you want to buy $ 10,000 of stock in X corporation, you will need to use $ 5,000 of your own money, and the additional $ 5,000 will come from the margin loan. Other types of titles may have different requirements.
- The initial requirement: Typically, the Financial Industry Regulatory Authority requires an initial margin for all investors: a deposit of $ 2,000 in the margin account — or the equivalent value in securities — before they can begin buying securities on margin. For model day traders, a minimum equity amount of $ 25,000 is required. Finra defines a “day trader pattern” as someone who executes at least four “daily trades” within five business days.
- How much money should be kept: Once a security is purchased on margin, Finra generally requires a “maintenance margin”, which means that the equity in your margin account must not fall below 25% of the current market value of the securities. your account. Some brokerages often require larger maintenance margins, such as 30% or more. If the minimum maintenance requirement is not maintained, you may be subject to a margin call, or an alert from your brokerage firm to increase your account equity. Some brokerages may require quick action, while others may allow several days to respond to the call.
For example, you buy $ 10,000 of shares in Company X by borrowing $ 5,000 on margin. At the time of purchase, the shares are priced at $ 10, so you own 1,000 shares.
If the stock price of Company X falls to $ 8 a share, the market value of the investment falls to $ 8,000. As a result, the amount of equity in your account – or the amount you own after taking into account what is owed to the brokerage – is $ 3,000. If your brokerage sets the holding margin at 25% of the value of the securities, you will need to keep $ 2,000 in the account. At $ 8 per share, you would have enough equity in your account to meet maintenance requirements.
But if the stock fell to $ 5.50 a share, the value of the investment would drop to $ 5,500, which means you only have $ 500 in equity. This is not sufficient to meet the maintenance margin requirement of $ 1,375 (25% of the current value of $ 5,500), and therefore the brokerage may issue a margin call. In this case, you will need to deposit $ 875 in cash to meet it. Fully paid and marginable securities may also be deposited into the account or you may sell securities to cover the deficit.
The advantages and disadvantages of buying on margin
Investing on margin can provide you with significant benefits. But the strategy involves significant risks.
“When you buy securities with borrowed funds, on the one hand, you can amplify your gains, but on the other hand, you may amplify your losses,” said Gerri Walsh, senior vice president of investor education at Finra. “Knowing that you can lose more money than you actually put into a margin account is one of the biggest risks investors need to understand. ”
Wealth managers and investors alike say there are advantages to investing on margin, namely the ability to have more purchasing power without having to sell other securities to raise funds.
Continuing with the example above, imagine that after purchasing $ 10,000 of shares of Company X (1,000 shares for $ 10 each), using a $ 5,000 margin loan, the price of the share climbs to $ 25. Then you sell the shares for $ 25,000. You must remit the $ 5,000, in addition to the interest charged on the loan, to the brokerage firm. That leaves you with $ 19,500 if the interest was $ 500, of which $ 14,500 is profit after paying $ 5,000 upfront.
On the other hand, if you had bought $ 5,000 from Company X without using a margin loan (500 shares for $ 10) and the share price had risen to $ 25, your investment would be worth $ 12,500, or a profit of $ 7,500 after sale.
Investors say there are other benefits. As long as you are able to maintain enough equity to meet your maintenance margin requirement, there is no set timeline for the repayment of the margin loan. Additionally, the interest rates for margin loans tend to be cheaper than other forms of loan, such as a credit card loan.
Margin loans can also be used for purposes other than investing. Some investors use margin loans to facilitate large purchases by consumers due to the lower interest rates.
Even with the potential for large gains, margin investing also offers the possibility of large losses, even when you are not facing a margin call.
Continuing with the examples above, imagine that the shares of Company X fall to $ 8 from your original purchase price of $ 10. In this scenario, you similarly used $ 5,000 of your own money plus a $ 5,000 margin loan to buy 1,000 shares for $ 10,000.
Even if you have enough equity in your account to avoid a margin call, you still choose to sell your investment for $ 8,000. After you pay off the loan, plus $ 500 in interest, you are left with $ 2,500, which means you’ve lost half of your original investment of $ 5,000.
However, if you hadn’t taken out a margin loan and instead bought only 500 stocks for $ 10, your losses would be less severe. When you sell for $ 8 a share, you receive $ 4,000 from the sale. That’s a loss of $ 1,000 on your initial cash investment, less than what was lost with a margin loan.
As seen above, one of the disadvantages of investing on margin is that additional costs are also generated by the interest on the loan. Interest rates vary depending on the amount of money you borrow. For loans under $ 25,000, industry-wide interest rates tend to hover around 8%, but rates generally decrease as the amount borrowed increases. Robinhood Markets Inc. recently lowered its annual margin interest rate for eligible clients to a fixed rate of 2.5% on any amount used above $ 1,000.
Other risks exist. Many companies will attempt to notify you of margin calls, but they are not required to do so, according to Finra. You are also not entitled to an extension of time to respond to a margin call, and in the event of significant market volatility, a broker may take immediate action to sell securities on your account. And when a broker sells your securities to meet the maintenance margin requirement, you can’t choose what gets sold.
Additionally, brokerage firms can increase their maintenance margin requirements at any time. It is important to read your brokerage firm’s client agreement before trading on margin.
“Margin is almost like a weapon,” said Dennis Notchick, private wealth advisor at Stratos Wealth Advisors. “And you really have to know when to use it right.”
- Investor Bulletin: Understanding Margin Accounts: A newsletter for investors from the SEC’s Office of Investor Education and Advocacy that explains the risks and rules surrounding margin investing.
- BrokerCheck by Finra: A free tool from Finra that allows users to search for brokers and brokerage firms, as well as investment advisers. The website provides information on licenses and details any complaints that may have been filed against them.
- Clever Finra investment course: A series of e-learning modules from Finra designed to strengthen investment knowledge and skills.
- Borrowing against oneself. Columnist Jason Zweig reviews the dangers of buying on margin, even when stocks and bonds are inflated with earnings.
- Margin calls bite investors, banks. Reporters Michael Wursthorn and AnnaMaria Andriotis recount a period in 2015 when lenders issued margin calls to clients after global markets fell.
- Investors are doubling their stocks, pushing margin debt to a record high. Journalist Michael Wursthorn highlighted in late 2020 how investors were increasingly borrowing from their portfolios, pushing margin balances to the first record in more than two years.
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