Buying on margin: Here's the skinny about what it is and how it works

Buying on margin allows folks to borrow money (usually from a brokerage) to snap up more stocks or other securities than they’d otherwise be able to afford. By accessing, or leveraging, existing capital to increase their purchasing power, they're shooting for a boost in their returns. It's not a slam-dunk move, though: buying on margin can increase their potential profits, sure, but it also amplifies their potential losses. And that's why it's important to understand how buying on margin works, its advantages, and its key risks.

What is buying on margin?

Buying on margin involves making an initial payment to a broker for a portion of an asset's cost – for example, putting down 10% and financing the remaining 90% through what’s effectively a loan. Doing that lets investors use assets in their investment accounts, like stocks, as collateral to secure additional funding to make other investments. While margin buying can significantly amplify gains by allowing investors to purchase more securities than their cash alone would permit, it also increases their potential risk for losses.

If the value of the securities bought on margin (or used as collateral to make new bets) falls to a point where it doesn't meet the brokerage's required “maintenance margin” – the amount of real cash or assets needed to back a margin loan – the broker may sell off part of an investor's portfolio to cover the shortfall (and maintain the required margin percentage). That can result in heavy losses, since an investor is effectively forced to “sell low”.

How does buying on margin work?

The strategy effectively involves taking out a loan from a brokerage and using that money to make more investments than the individual's cash balance would’ve allowed.

It typically unfolds with margin traders or investors first depositing cash or securities into their brokerage account, which serves as collateral for the loan against which the brokerage lends money back to them. Next, armed with a higher cash balance, those investors can start to make more bets.

Federal Reserve "Regulation T" stipulates that investors are required to provide at least half of the purchase price of the securities in cash or other collateral. That’s known as the “initial margin”. And it’s worth noting that not all securities can be bought on margin – and for those that can be, brokers might have different margin rules (a.k.a. “house requirements”) that could be even stricter than the Fed’s.

The aim of buying on margin is to enhance potential returns, but that comes with increased risk. If the assets an investor buys on margin increase in value, their returns are magnified – happy days. But if those assets’ prices drop, an investor's losses can exceed the amount they initially put in, because they’re still on the hook for repaying the full loan amount as well as any interest.

Okay, how about an example?

Let’s look at a simple scenario without including interest costs, commissions, or “margin calls”.

Picture an investor who wants to buy 100 shares of Company A. The shares are worth $100 each (so 100 shares would cost $10,000 in total), but the investor only has $5,000 available. By buying on margin, the investor can use that $5,000 and borrow the remaining $5,000 from a broker to complete the purchase.

If the investor profits

A year later, let's say Company A’s share price has climbed to $200. The investor can sell the whole stake for a total of $20,000, repay the broker’s $5,000, and pocket the remaining $15,000. Without buying on margin, the investor would have doubled that initial $5,000 investment. But with it, the investor tripled it.

If the investor suffers a loss

A year later, let's say Company A’s share price has dropped by 50% to $50 instead. The investor sells up for $5,000 – and, after repaying the broker – is left with nothing: in other words, a 100% loss on that investment. By comparison, without using margin, that 50% stock drop would have merely halved the trader's total investment.

So how do you buy on margin?

Buying on margin involves careful consideration and understanding of both the process and the terms set by brokerage firms. Here’s how to get started:

• Understand your margin requirements.

  Your broker will set specific margin requirements, which include the minimum initial margin (the percentage of the purchase price you must initially fund) and the maintenance margin (the minimum account balance you must maintain). You’ll need to meet these requirements to start buying on margin.

• Open a margin account.

  This account is different from a standard trading account as it allows you to borrow money against the value of the securities you own.

• Deposit initial funds.

  Once your account is set up, deposit funds or securities to meet the initial margin requirement. That’s typically 50% of the purchase price of the securities you want to buy but can vary depending on the broker and the securities.

• Buy securities.

  You can purchase more securities than you could with just your available cash by using the borrowed funds. This allows you to leverage your investment to potentially increase your returns.

• Maintain your account.

  Keep an eye on your account balance relative to the market value of the securities you own. If the value of your securities drops below the maintenance margin, you’ll need to deposit more funds or sell some of your securities to bring your account back into compliance, avoiding a margin call.

• Respond to a margin call.

  If your account falls below the maintenance margin, your broker can issue a margin call, requiring you to immediately rectify the shortfall. If you fail to meet the margin call, the broker has the right to sell your securities to bring your account up to the required level.

Who should buy on margin?

Buying on margin is best suited for experienced investors who understand and can afford to take on the risks involved, and who can commit the time required for diligent monitoring of their bets. It’s probably best avoided if you’re still early in your investing journey, given the potential for pretty dramatic losses. For more traditional stock and bond investors, the additional risk buying on margin introduces might be unwarranted, but for certain folks – like those in the commodity futures market – margin trading is the standard. In any case, margin trading is best approached with caution.

What are the advantages and risks involved?

Buying on margin magnifies the financial outcomes of market movements, presenting both enticing opportunities and considerable risks.

Opportunities for higher gains

Leveraging assets through margin trading enables investors to make larger trades than their cash holdings would normally allow. This can significantly amplify potential returns, providing skilled investors with opportunities to capitalize on market movements more effectively.

Margin trading offers the advantage of leveraging existing investments without the need to sell them. This flexibility allows investors to maintain their positions while using them as collateral for further trading.

Can lose more than your initial investment

One of the primary risks of buying on margin is the possibility of losing more money than initially invested. For example, if stocks purchased with borrowed funds decline by 50% or more, the resulting losses could exceed the original amount invested, compounded by interest and commissions.

Margin fees

In addition to the inherent risks, margin trading incurs additional fees for maintaining margin positions. While the potential for gains can be high in favorable market conditions, these trades can result in substantial financial obligations far exceeding the initial capital if the market turns unfavorably.

What's the big takeaway then?

Buying on margin is a powerful investment strategy that allows investors to amplify their purchasing power by borrowing funds from a broker. While it offers the potential for substantial gains, it also comes with increased risks, including the possibility of significant losses and additional costs in the form of margin and interest fees. While margin trading can offer substantial rewards in bullish markets, the stakes are high, and it's crucial for investors to approach with caution. Buying on margin is best suited for experienced investors with a high tolerance for risk and a solid strategy for managing potential losses.