Intro to Margin
When you buy on margin, you borrow money from a broker to pool with your cash, buying more stock than you could by yourself. You're taking a loan, and using the securities that you own as collateral. One difference between this and a traditional loan is that the value of the collateral (the securities) can swing wildly from one day to the next. Buying on margin is riskier than paying with just cash - sometimes much riskier.
The other difference is that with many loans, people will borrow because they don't have enough in the bank to pay cash. But one reason for investing on margin is to benefit from leverage while you keep more of your cash available for other things.
What's leverage? It's strategic borrowing. With margin, you take a loan, in this case from your broker, because you expect to earn more on the investment than you'll have to pay in interest on the loan. In fact, when it works best, you score with a greater percentage profit than if you'd used only your own money. No surprise, then, about what happens if you strike out - you can lose more, too.
Note that tax regulations don't allow margin in retirement accounts; margin is a tactic that can only be used in individual or joint accounts.
You will need a margin account before you can trade on margin. If you are approved you'll be required to deposit at least $2,000 in either cash or securities (or a combination) that get the broker's okay. That's a Federal Reserve Bank rule, called Regulation T. It's insurance for the broker in case things go wrong.
With a margin account, you can borrow up to 50% of the purchase price of an eligible security, as long as your half - not including the $2,000 minimum - is available in your account. You give the buy order and the trade goes through.
Here's an example:
Let's say Jane Doe and Mara Smith each have $12,500 to invest today in a stock. Jane buys $12,500 worth of the stock at $25 a share, for a total of 500 shares. Mara uses margin to buy $25,000 worth of the same stock at $25 a share, for a total of 1,000 shares. She combined her $12,500 with a $12,500 margin loan from her broker.
The stock goes up, life is good!
The stock price goes up to $30 a share. Jane's investment is now worth $15,000. If she sells now, she's gained $2,500 or 20 percent of her original investment (before we deduct any commission charges).
Mara's total investment is now worth $30,000. If she sells now, she's gained $5,000 or 40 percent of her original $12,500 investment (again, before deducting commission charges, interest, or the loan amount). If the price rises quickly enough that Mara can avoid lots of interest charges, then Mara's in the pink.
The stock goes down, life is not so good!
The stock price drops to $20 a share. Jane's investment is now worth $10,000. If she sells now, she's lost $2,500 or 20 percent of her original investment (before we deduct any commission). But Mara's in worse shape. Mara's total investment is now worth $20,000. If she sells now, she's lost $5,000 or 40 percent of her original $12,500 investment (again, in round numbers). Since she still owes her broker $12,500, the value of her original investment has dropped to $7,500.
Mara can wait to see if things turn around - remembering that the longer she has the loan the more interest she'll pay - or sell now, repay what she owes, and eat the loss. But even if she doesn't sell, Mara may have a tough decision to make. That much of a drop may put Mara at risk for a margin call from her broker. That basically means she has to quickly put up more cash or sell some of the stock.
Part of your agreement for a margin loan includes a "maintenance margin" percentage set by your broker. You get a margin call when the equity in your investment drops below that percentage. For example, Mara's maintenance margin is 50 percent. When Mara's stock dropped, her equity dropped to $7,500. That's 37.5 percent of the current $20,000 value of the shares. Since her broker's maintenance margin is 50 percent, she's short 12.5 percent, or $2,500.
Mara gets a margin call saying she must deposit $2,500 in her account before the deadline her broker sets. Or, she could select securities to sell to come up with the $2,500 requested by her broker. If she doesn't "meet the call," her broker has the right to sell any assets in her account to make up the difference. At this point, the broker chooses what to sell; Mara doesn't.
If the price continues to drop, Mara will keep getting margin calls requiring more deposits. You can see where this is going. Mara could lose more than she invested.