3-05 Buying on Margin
When you are opening a real brokerage, you will be asked if you want to open a Margin Account. Buying on margin means that you purchase securities using some of your own cash and you take a loan from your broker to complete the purchase. The collateral for the loan is the stocks or cash you already own. The difference between the value of the collateral (securities) and the loan is called the “net value.”
Margin buying can be very convenient and cost effective. However, you should always maintain good control of these activities to avoid a financial problem in the future. This is a bit complex, but makes sense with some practice.
You can normally borrow up to 50% of the value of the securities you’re buying. There are also minimum margin requirements that must be maintained. Should your account or collateral fall below the minimum required, you’ll be issued a “margin call.” You’ll be required to add to your account or be forced to sell securities at their current market value, whether you want to or not. You should try to keep appropriate minimum margin requirements at all times. Margin calls can often be costly for you because they usually force you to sell stocks at low prices thereby locking in losses on your account.
The good news: You can maximize your buying ability by using less cash to purchase more shares. Your power will depend on the amount of leverage your broker allows. For example, most brokers have a 50% margin requirement which allows a 2:1 leverage ability. With 50% margin requirement, $10,000 deposit of cash by you in your brokerage account can be used to buy up to $20,000 of stock.
The bad news: You’ve maximized your buying power, but should your stock fall in value, your losses are maximized, too. Also, should your account fall below the margin minimum requirement, you’ll have to come up with more cash or stock to get your account back in compliance.
Here is a brief example that should clear away any fog. Assume you want to purchase 100 shares of LUV at $10.00 per share—that will cost $1,000. You decide to use $500 of your own cash and $500 borrowed from your broker. You’ve just made a margin buy. Your net value is $500 ($1,000 stock less the $500 loan). If the stock goes to $15 and you sell you will receive $1,500. The broker will take $500 to pay off the loan, and you pocket the other $1,000. In this example, you made a 100% return because you turned your initial $500 into $1,000. Had you not bought on margin you would have only been able to buy 50 shares at $10 for a total cost of $500, and then you would have sold your 50 shares at $15 for $750 or a profit of $250 or 50%.
Likewise, if you bought 100 shares on margin and the stock went down to $5 and you sold that $500 from the sale would go to payoff your loan and you would be left with $0—meaning you lost 100% of your investment on a 50% decrease in stock price.