Title: Buying on Margin — a practical explainer
Definition (plain): Buying on margin means using borrowed money from your broker to buy securities. The investor puts up part of the purchase price (the equity), and the broker lends the remainder using the securities in the account as collateral.
Key jargon (defined)
– Marginable securities: assets that a broker will accept as collateral for a loan. Not all instruments qualify.
– Initial margin: the minimum percentage of the purchase price the investor must provide up front (Regulation T currently requires at least 50% for many stocks).
– Maintenance margin: the minimum equity that must remain in the account after the purchase, usually expressed as a percentage of the market value.
– Margin call: a demand from the broker to deposit cash or sell holdings when account equity falls below the maintenance requirement.
– Leverage: using borrowed funds to increase the size of a position relative to your own capital.
How it works — step by step
1. Open a margin account with a broker (different from a cash-only account).
2. Deposit cash or marginable securities as collateral.
3. Buy a security — broker allows you to borrow up to the allowed amount (often up to 50% for many stocks under Regulation T, though many brokers set higher requirements).
4. Pay interest on the borrowed amount; interest rates vary by broker and loan size and are charged to your account (typically billed monthly or daily accrual).
5. Monitor the position: if the market value drops and your equity falls below the maintenance margin, the broker issues a margin call.
6. Satisfy a margin call by depositing cash or selling holdings; if you do not, the broker can liquidate positions to restore required equity.
Worked numeric example (clean, step-by-step)
Assumptions:
– Buy 100 shares of XYZ at $100 each → total cost $10,000.
– Broker allows 50% initial margin. You invest $5,000 of your own cash and borrow $5,000.
Scenario A — price doubles to $200:
– Sale proceeds: 100 × $200 = $20,000.
– Repay loan: $5,000.
– Net to investor before interest: $20,000 − $5,000 = $15,000.
– Return on your $5,000 equity = ($15,000 − $5,000) / $5,000 = 200% gain (you ended with $15,000 total, i.e., tripled from the original $5,000 equity).
Scenario B — price halves to $50:
– Sale proceeds: 100 × $50 = $5,000.
– Repay loan: $5,000.
– Net to investor before interest: $0.
– Your $5,000 equity is wiped out → 100% loss of your invested capital.
Compare without margin:
– If you had bought without leverage (all cash, $10,000), a rise to $200 yields $20,000 → $10,000 profit (100% gain on $10,000).
– A fall to $50 yields $5,000 → $5,000 loss (50% loss on $10,000).
Simple return formula with margin:
Return on equity = (Market value − Loan − Initial equity) / Initial equity
Using Scenario A: (20,000 − 5,000 − 5,000) / 5,000 = 200%
Why margin magnifies outcomes
– Upside: profits are amplified because you control a larger position with less capital.
– Downside: losses are amplified; you can lose your entire invested equity and may be required to add funds or face forced liquidation. In extreme cases you can owe more than your initial cash if the account is liquidated at unfavorable prices or interest accrues.
Account rules and limits
– Federal Reserve Regulation T sets the initial federal standard (often 50% for many equity purchases), but brokers commonly apply stricter requirements.
– Brokers set maintenance margins and can issue margin calls or sell collateral without prior consent if requirements aren’t met.
– Some products (commodity futures, certain options strategies) are typically traded on margin; other securities may be ineligible.
Advantages (when used appropriately)
– Increase buying power without selling existing holdings (avoids immediate taxable sales).
– Potential to earn larger absolute profits when your view is correct.
– Useful for skilled, active traders who can monitor positions constantly.
Disadvantages and risks
– Higher potential losses — you
can lose more than your initial investment; leveraged losses are magnified. Other key disadvantages and risks include:
– Interest and carrying costs — brokers charge interest on the borrowed amount. Interest reduces return and compounds while positions are open.
– Margin calls and forced liquidation — if your equity falls below the broker’s maintenance requirement, the broker can demand cash or sell holdings (partial or full) without prior consent to restore the margin-to-equity ratio.
– Rapid losses in volatile markets — price swings that are manageable in a cash account can trigger margin events in a leveraged account.
– Owing more than your account value — if a forced sale happens at distressed prices or there are gaps (overnight news, delisting, corporate actions), you can end up owing money beyond your deposited equity.
– Behavioral risk — leverage can encourage overtrading, excessive position size, or poor exit discipline.
– Counterparty and rehypothecation risk — some brokers can rehypothecate (re-lend) your pledged securities; in extreme broker insolvency scenarios, recovering assets may be delayed or partial.
Worked examples and formulas
1) Buying power with Reg T initial margin (typical example)
– Formula: Buying power = Cash / Initial margin requirement.
– Example: Reg T initial margin = 50% (0.50). With $5,000 cash:
Buying power = 5,000 / 0.50 = $10,000.
You can buy up to $10,000 of eligible securities by borrowing $5,000.
2) Leverage magnifies percent loss on equity
– Setup: Buy $10,000 of stock with $5,000 cash and $5,000 margin loan.
– If stock falls 30%: market value = $10,000 × (1 − 0.30) = $7,000.
Equity = market value − loan = 7,000 − 5,000 = $2,000.
Dollar loss = 3,000; percent loss on equity = 3,000 / 5,000 = 60%.
3) Maintenance margin and margin-call threshold (solve for price)
– Definitions:
Equity = Market value − Loan.
Maintenance margin requirement M (fraction), e.g., 30% = 0.30.
Condition to avoid margin call: Equity / Market value ≥ M.
– Solve for minimum market value P_min:
(P_min − Loan) / P_min = M => P_min (1 − M) = Loan => P_min = Loan / (1 − M).
– Example: Loan = $5,000, M = 30%:
P_min = 5,000 / (1 − 0.30) = 5,000 / 0.70 = $7,142.86.
Starting from $10,000, the stock can fall about 28.57% before triggering a margin call.
4) Shortfall amount if margin call occurs
– When current market value P1 < P_min:
Required equity = M × P1.
Current equity = P1 − Loan.
Shortfall = Required equity − Current equity (if positive).
– Example: P1 = $6,000, Loan = $5,000, M = 30%:
Required equity = 0.30 × 6,000 = 1,800.
Current equity = 6,000 − 5,000 =
= 1,000. Shortfall = 1,800 − 1,000 = 800.
Interpretation and immediate consequences
– The account is short $800 of required equity. The broker will issue a margin call for at least $800.
– To satisfy the margin call the investor must either (a) deposit $800 in cash or marginable securities, or (b) the broker may liquidate positions in the account until the maintenance requirement is met. Brokers are not required to contact you before selling; they can sell without your consent.
Worked check (after depositing cash)
– If you deposit $800, new equity = 1,000 + 800 = 1,800.
– New equity-to-market-value ratio = 1,800 / 6,000 = 30% = M. The account is then exactly at the maintenance requirement.
General formulas (recap)
– P_min (market value that triggers margin call) = Loan / (1 − M).
– Shortfall when P1
current equity, Shortfall = required − current.
5. Options to resolve:
– Deposit cash (amount at least = Shortfall).
– Deposit other marginable securities (check broker acceptance).
– Transfer