What Is Buying Stock on Margin?

By W D Adkins

  • Overview

    Buying stock on margin is a way of leveraging short-term stock purchases to increase profit potential. When you leverage a transaction you put only part of the price of the stock up. As a result you can purchase more stock for the same investment and thus make more money if the price goes your way. However, the risk is also greater, because if you guess wrong, your losses are also greater. Before you try your hand at buying stock on margin, you should have some experience at regular stock trading and thoroughly learn the rules (and the risks) of this trading strategy.
  • Identification

    A stock purchase on margin is one in which the investor puts up part of the purchase price and the broker loans her the rest. The amount the investor must put up is called the margin requirement (set at 50 percent by the Federal Reserve Board as of 2009). By borrowing the rest an investor can secure twice as many shares of a stock, doubling any profits or losses.
  • Requirements

    For buying stock on margin an investor has to have a margin brokerage account (rather than a simple cash account). Because the broker is extending credit, special requirements apply to margin accounts. The broker is required to inform an investor of all risks associated with margin trading and a minimum of $2000 is required to open a margin account. Investors must sign a "hypothecation agreement" that states that all cash and securities in the account are collateral for funds borrowed from the broker.
  • Function

    Once an account is set up, buying stock on margin is a simple matter of placing the order with your broker much as you would a regular stock purchase (as long as you have sufficient funds in the account to meet the margin requirement). The broker charges interest on the borrowed money, usually at a low rate. Generally margin purchases are limited to stocks trading at $5 a share or more. Margin purchases are short-term and are closed out in a few weeks or at most months.
  • Margin Calls

    If the stock you bought on margin goes up your equity increases. However, if the stock price falls you may have a problem. The equity in your stock must remain at the "minimum maintenance requirement" (the New York Stock Exchange sets this at 25 percent but a broker may require more). For example, if you bought stock worth $4000 with $2000 cash and the rest on margin and the stock value falls to $2600 your equity falls to $600, which is less than 25 percent of the remaining value of the stock. At this point your broker will issue a margin call. You must either add money to your account or the broker will sell the stock.
  • Features

    Buying stock on margin is a standard strategy for day traders. Because of the rapid turnover in transactions and risks of this trading strategy a day trader will typically be required to keep a minimum balance of $25,000 in a margin account. Making securities transactions on margin isn't limited to buying stock. Margin trading is also used for bonds and options. Some types of securities transactions, such as selling stock short, foreign exchange trading and commodities trading, are done on margin and not by outright purchase.
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