What is Buying on Margin? Your guide to gaining magnified exposure to assets
Margin trading allows traders to increase their purchasing power by borrowing money from their brokerage company.
If used safely, buying on margin can boost profits. However, it is critical for traders to understand the risk of magnified losses and margin calls when using margins to buy securities.
What does buying on margin mean and how does it work? Here we take a look at everything you need to know about margin trading and the risks associated with it.
What is buying on margin?
According to the US Securities and Exchange Commission (SEC), the buying on margin definition is:
The use of margin increases a trader’s purchasing power, allowing them to own more securities without having to pay for them in full on the day of purchase. Traders use margin buying to maximise their profits. It also exposes them to the risk of higher losses.
Like any borrowing, traders will have to pay back their margin loans to the brokerage regardless of any profits or losses made from it. Interest on the margin loan may vary from one brokerage to another. Margin trading can also be used for short selling.
According to the US brokerage regulator, the Financial Industry Regulatory Authority (FINRA), firms can lend a customer up to 50% of the total purchase price of a margin security for new or initial purchases.
How does buying on margin work?
Traders need a margin account to access margin loans. A margin account is one of two types of brokerage accounts. The other is a cash account, where the holder pays for securities purchased in full.
Margin accounts allow holders to use their account as collateral to borrow money from the broker to purchase securities. A number of brokerage firms allow both margin accounts and cash accounts at the same time.
Once a trader has a margin account set up, they can take a margin loan. The loan depends on the leverage ratio offered by the brokerage, which specifies the amount of leverage or borrowed money an account holder can use. Leverage ratios vary for different types of asset classes and among brokerages.
Margin trading example
Let’s take a look at an example of buying stock on margin, assuming that the leverage ratio offered by the brokerage for using margin to buy stocks is 2:1. At a leverage ratio of 2:1, the account holder can borrow 50% of the money required for the stock purchase.
You can now buy ABC stock worth $100 by paying $50 of your own money and the remaining $50 using margin.
If the stock price of ABC rises from $100 to $150, you would have made a 100% gain on the money you invested from your own pocket – a profit of $100 is made from your investment of $50. You will have to return $50 plus interest to the brokerage.
Let’s now look at the risk of increased losses using the same buying on margin example. If ABC stock falls from $100 to $50, you will lose 100% of the money you invested from your own pocket. You will also have to pay back the margin loan plus interest to the brokerage.
If you had bought ABC stock by paying for it in full from your own pocket, your loss when the stock price falls from $100 to $50 would be 50%.
Understanding margin calls
The use of margins in trading has its pros and cons. It’s crucial for traders to fully understand the risks involved when buying on margin, such as being unable to meet a margin call.
As referred to earlier, brokerage firms require margin account holders to maintain a certain percentage of equity in their accounts as collateral for margin loans.
There may come a time, especially in highly volatile markets, when traders using margin will be required to provide additional capital to their account if the price of their stock collateral falls below the minimum maintenance margin requirement. This event is called a margin call.
“Normally, the broker will allow from two to five days to meet the call,” FINRA said in a blog post. “The broker’s calls are usually based upon the value of the account at market close since various securities regulations require an end-of-day valuation of customer accounts.”
Brokerages have the right to sell the securities bought on margin if the trader fails to meet margin calls. In such an event, the trader may incur substantial losses and will miss out on the chance to recover if the market rebounds. FINRA added:
FINRA also requires margin account holders to deposit a “minimum margin” of $2,000 or 100% of the purchase price of the margin securities, whichever is less, with their brokerage firm before trading on margin.
Risks associated with buying on margin
According to the US SEC, there are other risks that traders should know about when using margin to buy securities. They are as follows:
The use of margin loans may multiply losses on investment.
Margin loans incur interest.
Traders may be forced to sell some or all their securities when stock prices fall.
Brokerage firms may sell securities without consulting to pay off margin loans.
Traders are not entitled to an extension of time on a margin call.
Brokerages can choose to increase margin requirements.
Not all securities can be purchased on margin.
The bottom line
Margin loans are useful tools available to traders. It is very important to remember the risk of magnified losses when using margin loans.
Traders can minimise risk by using risk-management tools such as guaranteed and ordinary stop-loss orders and take-profit orders. Traders can also consider leaving a cash cushion in their margin accounts as a safeguard against margin calls.
Paying interest regularly and keeping debt at sustainable levels can be useful ways of reducing risk when buying on margin. Most importantly, traders must take time to study the asset they wish to trade, looking at fundamental and technical analysis, and acknowledge the unpredictability of financial markets.
Remember that your decision to trade should depend on your risk tolerance, expertise in the market, portfolio size and goals. Never trade money that you cannot afford to lose. And always conduct your own due diligence.
FAQs
When should you buy on margin?
Traders can use margin loans only after fully understanding the risks involved of buying on margin. They must be aware of risks like margin calls, and stay in line with their minimum maintenance margin requirement.
Is buying on margin profitable?
Buying on margin can be profitable. It can also lead to magnified losses. Traders can minimise risk by using risk-management tools such as guaranteed and ordinary stop-loss orders and take-profit orders. Traders can also consider leaving a cash cushion in their margin accounts as a safeguard against margin calls.
How long can I hold a margin position?
The length of holding a margin position will depend on your brokerage. A brokerage will only allow you to hold your margin position if you meet the minimum maintenance margin requirement.
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