Understanding Buying on Margin
Aggressive investors often buy stock on margin to rapidly expand their profits. Through this trading strategy, you can buy more shares than you could normally afford. By using the money in your brokerage account, you can qualify to borrow money against stocks you currently own for a low interest rate. Let’s dig into what exactly buying on margin stocks means and why some investors take this risk.
- Buying on margin means that you are borrowing money from a brokerage firm to invest in stocks.
- Margin investing can become risky if you can’t pay off your debts. Even if you lose out on your stocks, you are still responsible for 100% of your loan payments.
- When opening a margin account, you need to meet the margin call, or your brokerage firm can sell off your securities. A margin call is when a brokerage firm requests that you add more securities and cash to your account.
What Is a Stock Margin?
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A stock margin is when you borrow money to pay for your stocks. When the average investor decides to purchase a stock, they can either deposit their funds into a brokerage account or fund their transaction by saving up their dividends, rent, and interest on existing investments. When investors don’t want to pay these two ways, they buy on margin. Essentially, you borrow money from your brokerage firm at a low interest rate. This gives you the ability to purchase stocks and other securities. In order to pay back this loan, your brokerage account serves as collateral.
One important thing to remember with margin trading is that your brokerage firm doesn’t share any of the risks with you. Even if you lose out on a trade, you still owe them the money you borrowed. It’s relatively uncommon for traders to have the right to set up payment plans or decide the terms of their debt. Another thing to note is that your brokerage firm can change the key terms at any point, and you must follow them. For instance, they may decide to change how much equity you need to have.
When your brokerage firm asks you to add cash or securities into your account, this is called a margin call. If you don’t have the means to do so, they have the right to sell your securities as they please. This is why only well-seasoned traders tend to choose this investment strategy. There is much more risk than traditional stock trading with a cash account.
When Do Investors Use Margin?
A lthough accruing debt can be a dangerous game to play, some investors can figure out how to use margin investing to their advantage. One scenario investors use it is when they need more financial flexibility. It gives them the chance to jump on a great investment opportunity even if they are currently low on capital. If the investment ends up working in their favor, the margin can be well worth the gamble.
You may also be inclined to use margin as an emergency fund. If the expense you need to cover has greater repercussions than the interest on your loan, it may work in your favor to borrow money from your brokerage firm. For instance, if you have an unexpected bill to pay, borrowing money to cover it may cost you less than the fine or fee associated with an overdue bill.
This is not to say that wise investors would use margin for other expenses that they expect. For instance, using margin for a down payment on a car, boat, or house may be unwise if you can’t afford it in the first place. This could lead to more debt on these assets and your margin account.
How to Buy Stocks on Margin
Follow these steps to start investing on margin:
1. Learn About Margin Accounts vs. Cash Accounts
The standard account investors use to trade is called a cash account. This type of account requires you to fully fund a transaction before it goes through. When using a cash account, you can’t acquire debt since you can’t lose more money than you deposited. When trading on margin, you must open a margin account.
The key difference between this and a cash account is that the securities (stocks, bonds, ETFs, etc.) in your account are held as collateral for what you borrowed. This means that if you miss a margin call, the brokerage firm will sell your investments until they reach their minimum equity ratio.
2. Open a Margin Account
Once you understand the risks of opening a margin account, you need to open one in order to start trading. You can then borrow money to start making trades. As you make your trades, remember that you need to pay your loan off. Most margin investors choose stocks that have a higher rate of return than what they owe plus the interest.
3. Meet Your Margin Call
As stated earlier, your brokerage firm can request that you add more securities and cash on a whim. That’s why you always need to stay on top of their terms and conditions as they change. This type of trading becomes risky if you don’t meet your loan payments or miss a margin call.
Qualifying for a Margin Account
As long as you meet the minimum cash requirements, also known as the minimum margin, it’s pretty simple to open a margin account. The Financial Industry Regulatory Authority (FINRA) has deemed $2,000 as the baseline minimum margin. In other words, you need to deposit at least $2,000 to open an account, although some brokerage firms may have higher minimum margins.
Upon qualifying for a margin account, all you need to do is fill out the application paperwork. You have the option to either open a new margin account or to add margin-trading capabilities to your existing brokerage account.
Risks Associated With Margin Investing
Many investors are wary of investing on margin because it can lead to serious adverse outcomes. For instance, if you fail to cover significant losses on your margin account, this could lead to bankruptcy.
Margin trading has a tumultuous past, especially at the dawn of the Great Depression. Maintenance requirements were 10%, and brokerage firms were giving out high loans. As the stock market began to take a dip, and brokerage firms made their margin calls, many investors couldn’t meet the maintenance requirements or pay their debts. This led to huge losses for investors who kept much of their wealth in the stock market since brokerage firms began to sell off their assets. This cycle of selling stocks to pay off existing loans ultimately played a part in the crash of the stock market.
When you trade on margin, you are also vulnerable to rehypothecation risk. This is when those who issue loans use the collateral for their own transactions and investments. Although this can work just fine, it can also lead to a collateral chain if one piece of collateral is used for more than one transaction. If everyone were to repay their debts, this wouldn’t be an issue. However, when people do fall behind on payments, this can make financial markets quite delicate, meaning that they are more at risk to crash if a transaction were to go poorly.
Rewards Associated With Margin Investing
A lthough the risks may seem overwhelming, some investors can make a large profit when they hit the market right. Along with having the ability to buy more stock than you can currently afford with your cash account, margin investing has many other benefits. For instance, buying on margin can give you fast, easier liquidity. It provides investors with the opportunity to transfer money more quickly, even if they don’t choose to buy stocks on margin.
Most cash accounts only allow you to withdraw cash from a stock three days after selling your securities. With a margin account, you can borrow this same amount of money right away while you wait for your trades to go through. Keep in mind that you still need to pay interest, though this amount is often irrelevant to investors who want their money right away. For example, if you’re only borrowing money for a few days, your interest rates may only grow up to a few dollars a day.
Like any type of investment, investing on margin comes with risks and rewards. That’s why advanced investors are the primary demographic of this strategy. By getting to know margin investing better, you can make more informed investment decisions.