In a traditional brokerage account, you use your own money to buy securities. With a margin account, you borrow money from your brokerage firm to pay for some of your investment. When you leverage your investments in this manner, your gains are amplified — but so are your losses.
Here’s a look at the basics of buying stocks on margin, including both the benefits and the dangers.
Buying Stock on Margin
Two terms are important to know when buying on margin: initial margin and maintenance margin. Initial margin is the amount of an investment purchase you have to pay for with cash. On most investments, initial margin is 50 percent. Thus, if you buy $10,000 worth of stock, you’ll have to put up at least $5,000 in cash.
Maintenance margin is the absolute minimum amount of margin you need to keep in your account. The Financial Industry Regulatory Authority, or FINRA, requires that customer equity must never fall below 25 percent of the value of securities in an account. Most brokerage firms build in a buffer and require clients to keep 30 or 35 percent maintenance margin at all times.
How to Buy on Margin
To begin, you’ll have to open a margin account. For most securities, your buying power, or the amount of stock you can buy, is twice the amount of your deposit. Thus, if you open a margin account with $5,000, you can buy up to $10,000 of stock. In this scenario, if you borrow the remaining $5,000 from your brokerage firm, you’ll start immediately accruing interest charges on the $5,000 that you borrowed.
What Is a Margin Call?
If the equity in your account falls below the maintenance margin requirement, you’ll face a margin call. A margin call requires one of two actions to immediately increase the equity in your account. The first is to deposit enough money to get your account above the maintenance margin level. The second is to sell enough securities to satisfy the margin call. If you don’t resolve the issue immediately, your brokerage firm might liquidate your securities without your express permission.
Pros and Cons of Buying on Margin
The main pro of buying on margin is the upside leverage. Imagine buying 100 shares of a $50 stock, for a total cost of $5,000. If you buy that stock using 50 percent margin, you’d only put up $2,500, borrowing the remaining $2,500 from your brokerage firm. If the stock goes up to $75, your 100 shares are now worth $7,500, for a 50 percent gain. However, since you bought the shares on margin, after you sell the stock and use a portion of the $7,500 to pay off your margin loan, you’ve netted a profit of $2,500 while only investing $2,500 of your own cash. You’ve turned a 50 percent stock gain into a 100 percent investment profit.
The main con of buying on margin is your losses are amplified, just like your gains. Just like your gains can potentially be doubled on the way up, if you’re using 50 percent margin, your losses are magnified, too. In the above example, if your stock instead goes down from $50 per share to $25, you will have lost your entire investment. The $2,500 you net from the stock sale would pay off your margin loan, leaving you with nothing at all.
The other major con of margin investing is the interest charges. While you are waiting for your stock to go up, you’ll be paying interest on the money you borrowed from your brokerage firm. You’ll have to earn more than you’re paying in interest just to break even.
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