What is “Buying on Margin” and What Triggers a Margin Call?
By Kenneth Baker on March 19, 2019
Buying on margin is the purchase of an asset by using leverage and borrowing the balance from the broker’s firm. Before one can buy on margin, they must be approved by the broker and open a margin account. Typically, buying on margin starts with a down payment made to the broker for the asset being purchased. The investor will pay at least 50% of the asset’s value and the broker will finance the remaining 50%. The investor then puts up her marginable securities in her account for the collateral of the 50% borrowed funds. Investors are interested in this method because it increases their purchasing power.
This process is akin to a loan. When you buy stock on margin, your brokerage firm lends you cash, using assets in your account as collateral, to purchase securities. Like any loan, the debtor eventually must pay the lender back plus interest. Each brokerage firm will have varying interest rates that they use, but are typically lower than those linked with a credit card. Margin purchases are different to normal loans however because there is no re-payment schedule. Rather, the investor will pay a monthly interest charge attached to the brokerage account.
When you buy stock on margin, your brokerage firm lends you cash, using assets in your account as collateral, to purchase securities.
Before an investor can buy on margin, the broker will usually set an initial margin and the maintenance margin when opening a margin account. Initial margin is the percentage of the purchase price of securities (that can be purchased on margin) that the investor must pay for with his own cash or marginable securities. If you buy $100 worth of a stock on margin, the initial margin requirement would be $50 because it is 50% of the loan. You will then have one pay period (4 days) to deposit the $50 into your margin account. If you fail to deposit the requisite funds, the brokerage firm can liquidate the securities and sell them or demand payment.
The maintenance margin is essentially the minimum amount of money that must be in the account before the broker forces the investor to put in more money. Once an investor buys a security on margin, the maintenance margin goes into effect with Financial Industry Regulatory Authority (FINRA) requiring that at least 25% of the total market value of the securities be in the account at all times If the equity in a margin account falls below the maintenance margin, the broker will issue a margin call, which requires that the investor deposit more cash into the margin account to bring the level of funds up to the maintenance margin, or liquidate securities in order to fulfill the maintenance amount.
The upside to buying on margin is that it increases your purchasing power by doubling the amount you purchase with using someone else’s money. The advantage is when the share price increases and you make a profit, you only have to return the amount that the brokerage firm loaned you (plus interest). So, if you buy 1 share of company ABC at $100/share, you would spend $50 of your own money, and the brokerage firm would pay $50. Imagine the share price at some point in the future doubles to $200/share. You decide to sell. You will pocket $150 because the brokerage firm initially loaned you $50. Effectively, you tripled your initial money from $50 to $150 because you used the brokerage firm’s money to purchase more than you could have on your own.
With great upside come great risk. Margin accounts are highly regulated because margin trading has the potential to incur sky-rocketing gains, as well as colossal losses. Such losses are a huge financial risk, and if left unchecked can unsettle the securities markets, as well as potentially disrupt the entire financial market. If the stock price plummets, you will be on the hook for the money you put in and the money that the brokerage firm loaned to you in purchasing that stock.
Do you have questions about your investments or what is right for you? Kenneth Baker is an attorney at Halling and Cayo, a full service law firm in Milwaukee, WI and part of its Securities Litigation team. His practice is focused on securities litigation. Contact him at (-414-755-5021 or via e-mail at KJB@hallingcayo.com to see if he can help further educate you or recover lost funds.
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