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The Risks and Rewards of Buying on Margin
The Risks and Rewards of Buying on Margin
By: Wilmington Trust

"Margin" to a brokerage account is what a turbocharger is to an engine. Buying on margin can boost your returns dramatically, allowing you to increase the amount of shares you buy, while decreasing the amount of cash you put out. However, opening yourself up to such rewards consequently exposes you to a greater degree of risk. Buying on margin can be tricky business and it is not a venture on which a novice investor should embark.

A "margin account" is a brokerage account in which the brokerage firm lends you the cash with which to buy securities. As with any other type of loan, the brokerage firm charges a margin rate, which is interest that must be paid on the amount you have borrowed. The "margin" in the account is the amount of money or securities you must deposit in order to create a loan against securities held in the account. When you buy on margin, you essentially buy the securities with borrowed money, using the shares as collateral. As such, if the value of the shares drops sufficiently, you will be required to either deposit more cash into the account or sell a portion of the stock in order to maintain the margin requirements of the account. This is known as a "margin call."

Buying on margin is a sophisticated trading technique that can have a dramatic effect on the stock market in general. Congress realized the effect that unrestricted margin borrowing might have on the entire economy in the 1930s. In fact, excessive and unrestricted borrowing to buy securities was identified by Congress as one of the causes contributing to the stock market crash of 1929. Therefore, under the Securities and Exchange Act of 1934, Congress authorized the Federal Reserve Board to set initial margin requirements for client accounts. Currently, initial margin requirements are set at 50 percent of the equity's value when purchasing securities. That means that you would have to deposit 50 cents for every $1 borrowed from the brokerage firm. The Fed's Regulation T also sets the maximum amount of time granted to clients to deposit cash or equities to meet the initial margin requirements (typically the trade date plus 3 days, or a maximum of 5 business days after the trade date). The Fed is not alone in its authority to set initial and maintenance requirements for margin accounts. Brokerage firms may have requirements higher than those of the Federal Reserve Board.

Given these restrictions, how does a margin account work? Compared to a cash account, where the stocks are paid for in full, margin accounts allow you to buy more stock for the same amount of cash or, conversely, the same amount of stock with less cash. For example, in a cash account, you would pay $100 for 10 shares of stock that is valued at $10 per share. With a margin account, you would pay $50 for the same amount of shares, borrowing the other 50 percent of the cost on margin. If the stock price increases from $10 to $15 a share, the cash account client would realize a 50 percent return. However, the margin account client who borrowed 50 percent of the purchase price would realize a 100 percent gain.

A margin account, therefore, offers increased purchasing power for additional securities. You can borrow against your current holdings to purchase more securities. For example, if you own 100 shares of stock valued at $50 per share, your margin account is worth $5,000. You can borrow up to 50 percent of this value to purchase more stock. Therefore, you can use an additional $5,000 to make your purchase, which would make the market value of your account $10,000 and your debit balance would be $5,000.

This strategy provides leverage for trading, which means that you can purchase more securities for less money. Continuing with the example above, in which the market value of your account is $10,000, consider that the price of the stock rises from $50 a share to $75. Assuming that you have 200 shares, you would enjoy an unrealized gain of $5,000. Since you used margin to bring your market value to $15,000, your percentage gain would be 100 percent of the initial investment of $5,000.

Margin accounts can also be used to enhance anticipated gains from the short sale of a stock. Selling a stock short means that you would borrow stock from a firm and sell the stock with the hope that the stock's price falls. If the price falls, you would then buy it back at the lower price and return it to the broker, pocketing the difference. Margin accounts enhance the potential gains from this type of trading technique.

While the rewards of buying on margin can be great, the potential losses can be just as dramatic. For every 100 percent gain there is the potential for a 100 percent loss. In a cash account, your risk is limited to the amount of money that you have invested. In a margin account, your risk includes the amount of money invested plus the amount that has been loaned to you. As market conditions fluctuate, the value of your marginable securities will also fluctuate, causing a change in your overall account balance and debt ratio. As a result, if the value of the securities held in your margin account depreciates, you will be required to deposit additional cash or make full payment of your margin loan to bring your account back up to maintenance levels. Clients who cannot comply with such a margin call may be sold out or bought in by the brokerage firm.

With these risks in mind, margin accounts can still be considered an advantageous way to trade and realize gains in the stock market. Strategies include using margin to increase ownership of a security, without fully paying for the security. Margin accounts can also be used to generate cash for those who have excess equity in accounts and have lending needs. Borrowing on margin may not be for everyone and you should carefully consider your personal investment objectives, your financial situation, and your tolerance for risk before pursuing such an investment strategy. However, prudent use of margin accounts may be just the strategy your portfolio requires.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.

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