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Buying on MarginIntroductionIn this section, we will cover the basics of using margins. We will discuss the following:
Why Buy on Margin?Let's begin with an example. Suppose you believe that a particular stock will rise in price. It is currently trading at $10 per share and you believe it will soon hit $20. Currently you only have $3,000 in cash to buy 300 shares. You can borrow $3,000 on margin and invest the total $6,000 for 600 shares. If the stock hits $20, your holdings will be worth $12,000 and you can then sell them for that price. You pay back the $3,000 you borrowed, leaving you with your original investment of $3,000 and a tidy gain of $6,000 (before commissions and interest). The chance to magnify your earnings is what buying on margin is all about. However, if the stock declined to $7 a share and you sell, you receive only $4,200. From this amount, you must repay the $3,000 you borrowed. Thus, leaving you with $1,200 of your original $3,000, before commissions and interest. Buying on margin is a strategy for the short term, since holding on to borrowed money too long could result in a loss. You are responsible to meet all margin calls promptly and you are responsible to repay all funds borrowed on margin, even if this amount exceeds the value of your account. As with all investing, there is risk in buying on margin. One of the biggest reasons many people lost lots of money in the stock market crash of 1929 was that they borrowed too much and could not pay back their loans. The government stepped in soon after to create limits.
Rules for Buying on MarginAfter the market crash of 1929, the government enacted laws to help prevent the practices that led to the crash. Federal Reserve Board Regulation T sets margin requirements. Regulation T requires that the customer put up a percentage of the total investment amount. The Federal Reserve Board sets this percentage but changes it periodically to keep speculation under control. Currently the margin requirement is 50%. However, some brokerages may require more than 50 percent. You may use fully marginable or partially marginable securities you already own as collateral for the margin. Conversely, you may borrow up to 50 percent of the value of your marginable portfolio. The broker-dealer holds the marginable shares as collateral. You pay the broker interest and commissions on the transactions. To buy on margin, you must have a margin account. You can put up your collateral in cash or securities. You are allowed to add money or securities to your account. The initial margin is the smallest amount that the investor must pledge at purchase. The bare minimum that must stay in the account is the maintenance margin. When the balance falls below this amount, if the margined securities drop in value, the investor will get a margin call, which is a demand that the account be brought back up to the maintenance margin. If the customer cannot meet the margin call, the broker may sell any and all of the customer's margined securities and other assets to meet the call. The NASD requires maintenance margin on equities of 25%. However, your broker may impose higher margin maintenance requirements. The customer is responsible for any remaining deficit.
Which Securities Can Be Margined?The Board of Governors of the Federal Reserve System publishes a list of marginable securities. Most brokerages will extend margin on the following types of securities:
Always check with your brokerage firm to determine whether a security is, 1)marginable, and 2) if a higher maintenance requirement is imposed on the security. Some securities are marginable only up to a certain value of the security while still other securities are non-marginable all together. With an IPO, you must wait at least 30 days after a security has been traded in the secondary market before the security may become marginable. Mutual funds and certain options may not be bought on margin or used as collateral in a margin account. Buying on margin is usually simple, but it is risky. If you buy a security with it, and it nose-dives in value, you cannot rescue it with more margin buying. Margining magnifies earnings, and it can magnify losses as well.
Selling ShortMargin accounts are not just used for buying -- you can also use them to sell securities. This is called selling short, or shorting. You can read more about selling short in the next section.
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