Meaning of Buying Stock on Margin

By W D Adkins

  • Overview

    Buying a stock on margin is a short-term trading strategy traders use to maximize potential profits. A margin purchase lets you put up only part of the cost of the stock, enabling you to buy more shares. However, when you leverage a stock purchase this way, you also increase the risk because if the stock falls in price, your losses will be increased by the same proportion as any profits would have been. If you are beginning to invest in stocks, get some experience with regular stock transactions and learn the details involved in buying a stock on margin before you attempt this trading strategy.
  • Identification

    When an investor buys a stock on margin he puts up cash for part of the price of the stock, which is called the margin requirement. He then borrows the remainder from the broker. The minimum margin requirement is set by the Federal Reserve Board and as of 2009 has been 50% for several years. The investor pays interest on the borrowed money plus whatever transaction fees apply. The advantage, of course, is that by leveraging a trade this way, you can purchase twice much stock, potentially doubling your profit.
  • Requirements

    A regular (cash management) account at a brokerage firm does not allow margin privileges. To carry out leveraged transactions you need a margin account. This requires the same information as a cash account (valid ID, place of employment), plus a statement of your income and net worth. Margin accounts have minimum deposits of $2000 (more for some types of trading) and you must sign a hypothecation agreement. This allows the broker to liquidate securities in your margin account if necessary to recover the money loaned for a margin purchase. All cash and securities in the margin account are collateral for any borrowed funds.

  • Function

    The actual process of buying a stock on margin is not much different than a regular stock purchase. Simply make sure you have enough money in the margin account and notify your broker. If all goes well, when it comes time to sell, you make a larger profit than you could with a conventional stock purchase. There are some limitations. Brokerage firms normally limit margin transactions to stocks with a price of at least $5 a share. Day traders use strategies that involve rapid turnover of stocks and are required to have a minimum balance of $25,000 or more.
  • Calls

    If you read the market wrong when buying a stock on margin and the price falls too much, your broker is required by law to issue a margin call. For the protection of both brokerage firms and investors, stock exchanges set a more restrictive "minimum maintenance requirement." For NYSE listed stocks your equity in the stock must be at least 25% of the market value. For example, if you buy stock on margin at $40 a share (putting up $20 per share) and the price falls to $26 a share, your equity falls from $20 to $6 per share---which is less than 25% of $26. You will get a margin call from your broker. At that point you must either add cash to your account or the brokerage firm will sell the stock.
  • Features

    Experienced stock traders have developed a number of strategies to limit the greater risks and maximize the profit potential associated with buying a stock on margin. An example is the "buy to hold" technique. If a stock you've bought on margin has risen in value, you can sell it and take your profit. However, since most margin trades are short term, you don't get capital gains on the profit. If you buy a "put" option for the same number of shares at the price you want to protect, you then have the right to sell at that price until the option expires. Then you just wait for the one year mark to pass, sell the stock and get the tax break.
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