Whenever you buy a new home or new car there are different financing avenues available to you. In most cases people use some of their own cash and take out a loan to finance the rest of the deal. The same can be done in stock trading as well. We refer to this as buying on margin. Buying on margin is simply borrowing money from a brokerage firm to purchase a stock. It allows you to leverage your cash and investments to purchase more than you otherwise could. In this article, I will be breaking down the basics of margin and going over the pro’s and con’s.
In my previous article, Understand the Rules Before You Play the Game, we discussed the rules surrounding a cash account. A cash account allows you to trade with the funds that are in your account and nothing more. To leverage your investments, you will need to open a margin account. By law, whoever you decide to open an account with is going to need to obtain your signature to open a margin account. These days this is all done electronically and anyone can do it. The minimum initial investment to trade on margin is $2k but some firms may have higher minimums.
Now that the margin account is open, you borrow money from a broker to purchase stocks up to double the account’s cash balance. To word this differently, it means you only have to put up 50% of the initial investment to purchase a stock. Let’s say you wanted to buy 1,000 shares of Disney and it is trading at $10 a share. Could you do this with just $5,000 of your own money? Yes! Just like a tradition car loan you don’t have to borrow the full 50% if you do not want to. You can borrow 10%, 25%, or whatever amount you wish to leverage. Keep in mind the more you leverage, the more risk you are taking on.
You can keep this loan as long as you want but there are certain obligations that you have to fulfill. First, whenever you sell a stock in your margin account, the proceeds will go to the margin balance until it is fully paid. For example, an investor with $5,000 in a margin account buys Disney’s stock for $10 per share. With the broker’s $5,000 loan, the investor purchases $10,000 of Disney’s stock and receives 1,000 shares. The stock appreciates $20 per share, and the investor makes $10,000. When the investor goes to sell those funds the first $5,000 of proceeds goes to pay off the funds that were borrowed and the remaining $5,000 the investor gets to keep as profit.
Second, let’s think of worst case scenario. Let’s say that we leverage money to buy Disney stock like in the last example but this time Disney stock starts to fall. To protect yourself and the firm there have been regulations put into place if your account value falls to a certain amount. The federal standards for the minimum percentage of equity that you have to maintain is 25%. Some brokerage firms have “houses minimums” that might require you to maintain 30% or greater. If your account falls below these minimums, then a margin call will be issued. A margin call requires you to either bring in funds to bring the account back above 25% or sell some of your stock to cover the balance. Let’s say you purchase $20,000 worth of Disney stock by borrowing $10,000 from your brokerage and paying $10,000 yourself. If the market value of Disney drops to $15,000, the equity in your account falls to $5,000 ($15,000 – $10,000 = $5,000). Assuming a maintenance requirement of 25%, you must have $3,750 in equity in your account (25% of $15,000 = $3,750). In this case, you’re fine in this situation as the $5,000 worth of equity in your account is greater than the maintenance margin of $3,750. But let’s assume the maintenance requirement of your brokerage is 40% instead of 25%. In this case, your equity of $5,000 is less than the maintenance margin of $6,000 (40% of $15,000 = $6,000). As a result, the brokerage may issue you a margin call.
Just like a traditional loan, you are going to have to pay interest on the running balance. The interest rate will vary depending on the brokerage firm but it accrues daily and gets charged to the account monthly. This amount is debited to the current margin balance and grows over time. There is no set time that you have to pay the margin interest. Just know that as it occurs the interest you will be paying will grow larger and larger. For this reason, many investors use margin for short-term investments so that do not have to pay a ton in interest payments.
Not all stocks are able to be bought on margin. These exclusions encompass stocks that involve a great deal of risk to start off with and that risk would be compounded with the use of margin. These stocks include penny stocks/pink sheet stocks and IPOs. Some brokerage firms will also hold special margin requirements for certain securities because they are extremely volatile.
The single biggest advantage with margin is that it allows you to invest twice as much as you could with the cash in your account. You are able to amplify your returns while using the brokerage firms cash. Let’s take a look at another example. We’ll keep with the numbers of $20,000 worth of stocks bought using $10,000 of margin and $10,000 of cash. Disney is trading at $100 and you feel that it will rise dramatically. Normally, you’d only be able to buy 100 shares (100 x $100 = $10,000). Since you’re investing on margin, you have the ability to buy 200 shares (200 x $100 = $20,000).
Disney then reports its partnering with Apple and the price of shares skyrockets 25%. Your investment is now worth $25,000 (200 shares x $125) and you decide to cash out. After paying back your broker the $10,000 you originally borrowed, you get $15,000, $5,000 of which is profit. That’s a 50% return even though the stock only went up 25%. A 50% return on a trade is amazing!
As much as we like to drool over a 50% return, we could just as well have a 50% LOSS if things turn against us. In volatile markets, prices can fall very quickly. The more you leverage an investment, the quicker you can see your principal get wiped out. If you fall into a maintenance call you will have to sell some of your stock or bring in more money to cover the position. The brokerage firm holds the right to sell you out of your position at anytime to cover the maintenance. Even scarier is the fact that your broker may not be required to consult you before selling! Under most margin agreements, a firm can sell your stocks without waiting for you to meet the margin call. You can’t even control which stock is sold to cover the margin call. Most brokers will give you till the end of the trading day to sell stocks or bring in funds to the account before they will sell you out. Because of this, it’s imperative that you read your brokerage’s margin agreement very carefully before invest. Returning to our example of exaggerated profits, say that instead of rocketing up 25%, our shares fell 25%. Now your investment would be worth $15,000 (200 shares x $75). You sell the stock, pay back your broker the $10,000, and end up with $5,000. That’s a 50% loss which otherwise would have been a loss of only 25%.
If you are new to investing, I strongly recommend that you stay away from margin until you build a proven track record of success. Even when you feel ready for margin trading, remember that you don’t have to borrow the whole 50%, you can start by leveraging less and taking on less risk. Margin can be a great tool to maximizing your returns as long as you don’t start taking on enormous amounts of risk. Keep your risk tolerance in mind with every trade that you enter. Always have an exit strategy in place so that you avoid maintenance calls
Homework: Think about if you are ready to start a margin account right now and come up with a strategy to slowly integrate yourself with leveraging more money. What amount of leverage is in line with your goals and risk tolerance at this point in your life?