What is Margin Buying in Stocks or a Margin Account?
Margin buying in stocks works like this (a simplified summary): You open a margin account with your broker, which is an account where your broker will extend you some credit for buying stocks. Federal Reserve regulations state that in any stock purchase, half of the purchase must be made with cash while the other half can be with a loan from your broker. Thus, think of it as being like a matching-funds account with your broker.
How does margin buying in stocks work?
By way of example, if you put $10,000 cash into your margin account to purchase stocks initially, your broker will loan you up to another $10,000 (with a likely fee attached plus interest over time) on the money you keep in that count toward buying stocks. That means you can purchase up to $20,000 in stocks using your margin account. Thus, you “leverage” your money by matching it with some of the broker’s money.
Stocks “bought on margin” must be kept in the margin account as collateral. Whenever they get sold, the broker gets paid back first, so your stocks fully collateralize the broker’s loan. The first time you make a purchase, the stocks you purchased are equal in value to what you paid for them, using your money and the brokers, (the market value), so the broker’s money is more than fully collateralized, even if you used 100% of the money you deposited in your margin account.
After you make the initial purchase, the Federal Reserve requires a “maintenance margin” of 25% equity in the margin account. So, let’s say you spent $20,000 on stocks, using the $10,000 you had in cash in our account and your broker’s matching loan. Your immediate equity in that $20,000 worth of holdings that are part of the account is $10,000. (I.e., that’s what you actually own when the stocks are sold, less any fees or interest owed.)
Then let’s say the stocks’ value drops by half. You have no equity left in your margin account because value of the stocks in the account is now $10,000, and they are securing the broker’s loan of $10,000. On top of the you may still owe fees and interest to the broker.
That’s why the Federal Reserve will only let you get to where you still have 25% equity in the margin account before you have to add cash to your margin account. If the stocks drop enough in value to where you no longer have 25% equity, you have to add more cash as equity into the account or offer more quality securities as collateral.
Note that recent regulation changes allow the Federal Reserve to change this “maintenance equity” limit.
What is the extra risk of margin buying in stocks?
The simple risk is, of course, that the broker can sell the stocks (make a “margin call”) once the stock value gets down to where you only have that 25% equity. Your broker gets fully repaid, and you get whatever is left over.
The broker and the Fed wants to make sure there is also enough equity to cover the fees and interest that are owed the broker. Sometimes, however, the broker will have a safety margin requirement that allows the brokerage to make a margin call before things get to that 25% point mentioned above.
When the margin call is made, you will usually have the option of putting more cash into the account to make up the loss in value so that the broker is still fully covered by the equity value of the stocks and the cash in the account (like adding more to the downpayment you made on your house so that you now have more equity in the home).
Thats why it’s called a “call.” The broker notifies you to give you a brief time to add cash into your margin account to maintain that minimum maintenance margin. However, the contracts with some brokerages stipulate that they don’t have to give you that call that gives you a chance to cover the stocks. They can just sell the stocks immediately without your consent.
There is more amplification of risk here than losing all or more. If you buy stocks with cash, and your stocks’ value falls by half, you may lose nothing because you can hold the stocks as long as you want and hope they go up again someday. Buying on the margin, however, means you also lose the ability to just sit the losses out wherein you may have been able to recover the full loss and even made a profit.
Your broker will sell all of them, and you have nothing. If they fall by more than 50%, you not only lose your deposit into our margin account (assuming you used the full leverage available when you bought the stocks) but you still owe the brokerage fees and interest. The fact that the collateral no longer covered the full loan doesn’t mean you’re not on the hook for everything that wasn’t covered by the sale.
What are the benefits of margin buying in stocks?
If the stocks go up in value, however, that gives you additional equity in your account, so you could use that expanded equity to collateralize additional purchases where you use your own money and borrow up to half of the purchase price again from your broker. Thus, stocks are called sometimes called “equities” — a variety of assets that can be used as collateral. (You still have to pay 50% in cash on the initial purchase.)
Investors who are confident they know what they’re doing, love to buy this way, as it greatly increases how many assets they can acquire with their own available cash flow, basically doubling their money.
None of this should be construed as investment advice. It is just intended as a simplified summary or margin buying in stocks.