Buying on margin, in the simplest terms, is borrowing money from your brokerage to purchase more stock or other investment, while using your initial capital as collateral. There are many brokerages that include margins as a part of their standard offerings.
Most margin accounts in the Unites States require an initial minimum amount of $2,000 in cash or securities, where you can then borrow up to 50 percent of the purchased stock per the Federal Reserve Board’s standards. Investors can hold a margin position as long as they’d like, however, it is normally recommended for short-term strategies. Once an investor decides to sell their stock, the returns go first to the broker as they collect their investment as well as the interest on the loan.
Restrictions of Buying on Margin
There are regulations that are put into place in the U.S. by the Federal Reserve Board that monitor investors and brokers who choose to invest on margin. Their regulations stipulate that an investor can’t have an initial margin over 50 percent and they must maintain a maintenance margin of 25 percent.
The Federal Reserve Board also has control over which stocks can be bought and sold under margin accounts. As a general rule of thumb, investors are not allowed to purchase penny stocks, Over the Counter Bulletin Board (OTCBB) securities or Initial Public Offerings (IPOs). Along with the Federal Reserve Board’s limitations, many brokerages have their own stipulations regarding which stocks can and can’t be traded using margin.
Minimum Requirements for Setting Up a Margin Account
As discussed above, the initial deposit that an investor is required to make before they can begin trading, per the Federal Reserve Board’s regulations, is $2,000 or 100 percent of the stocks purchase price. Depending on the brokerage firm, their initial investment requirements may require more capital.
Margin Borrowing Amount for Investors
Due to regulations, a single investor can’t borrow more than 50 percent of the purchase price of the stock but they are not obligated to that full amount. Margin investors are not limited to borrowing a set amount every time they have the ability to borrow less as they see fit.
Maintenance Margin: Amount Investor Needs Post Trade
This is the amount of capital that the margin investor needs to maintain in their brokerage account while trading. If an investor’s account fails to meet the minimum account balance there will be a margin call, where the broker will either force the investor to deposit more funds into the account or sell stock to pay back the loan.
Advantages of Using Margin
The main advantages and appeal to trading on margin comes with the leverage and opportunity to increase the profit potential it provides. With the added leverage, there is an amplifying effect on every point that the investment goes up.
With the ability to buy twice as much stock with leverage, investors and traders have the potential to generate higher profits than they originally would be able to. The draw of this investment strategy lies in the opportunity of high rewards, but also presents the potential for higher risks in the market. This strategy may be especially useful when the market is less volatile.
Risks and Disadvantages of Using Margin
Buying on margin, like any investment strategy, isn’t without its risks. One of the primary disadvantages that come with buying on margin is the potential for a margin call. Unlike standard stock investments, you stand to lose much more when buying on margin due to the use of leverage. With every margin account there are margin securities held as collateral. In addition, investors have to pay interest on the debt to their broker.
The interest is applied to the account based on the outstanding balance. This in turn means that as the debt increases within the margin account, so do the interest charges. This is why borrowing on margin isn’t recommended for longer-term investments. The interest could end up costing the investor more than the returns that they gain on an otherwise profitable trade.
Another major drawback to buying on margin involves the fine print of the margin account agreements. If the funds in a margin account fail to maintain the maintenance margin, brokers have the right to sell securities to increase your account equity. They can do so without providing prior notice as well as having control over which stocks are sold.
The last major disadvantage of buying on margin is the simple fact that investors run the risk, particularly in highly volatile markets, of substantial losses that could end up being more than the initial investment.
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