Investing in the Stock Market: Part Three
Buying on margin entails borrowing money from a brokerage firm to purchase investments. In other words, it is a loan from a firm at which an investor maintains an account. To invest or trade on margin, one must open a margin account, which is different from a regular cash account, and the broker is required to obtain the account opener’s signature. The margin account may be part of the standard account opening agreement or a completely separate agreement. An initial deposit of at least $2,000 is required to open a margin account, though some brokerage firms require more. This deposit is known as the minimum margin. Once the account is opened and active, the investor or trader can borrow up to 50% of the purchase price of a stock. The portion of the purchase price deposited by the account opener is known as the initial margin; some brokerage firms require more than 50% of the purchase price. As mentioned, an account can be margined up to 50%, but one can always borrow less.
A margin loan can remain outstanding for a short or long period of time, provided all obligations are fulfilled. When stock in a margin account is sold, the proceeds first go to the broker for repayment of the loan until it is fully paid. There is also a restriction called margin maintenance, which is the minimum account balance that must be maintained before a brokerage firm will require additional deposits or sell stock to pay down the loan. This requirement for an additional deposit is known as a margin call.
Borrowing money in the form of margin has its costs. First, marginable securities in the account will function as collateral. Second, there will be interest charges on the loan, and the interest charges will be applied to the account unless payments are made. Over time, the debt level can increase as interest charges accrue against the account. As debt increases, the interest charges will increase. Therefore, buying on margin is typically used for short-term investments because the longer an investment is held, the greater the return needed to break even. The Federal Reserve Board regulates which stocks are marginable, and brokerage firms can also decide not to margin certain stocks. As a rule of thumb, penny stocks, over-the-counter Bulletin Board (OTCBB) securities, or initial public offerings (IPOs) are not permitted by brokerage firms to be purchased on margin because of the day-to-day risks associated with them.
A Buying Power Example
Begin with deposit of $10,000 in a margin account. Because 50% of the purchase price can be margined, buying power is actually $20,000. If $5,000 worth of stock is purchased, $15,000 in buying power will remain. Money will begin to be borrowed only when securities worth more than $10,000 are purchased. Therefore, a margin account’s buying power can fluctuate daily depending on the price movement of the marginable securities in the margin account.
The Margin Call
In the previous section, two restrictions were discussed as to the amount on can borrow. The first was initial margin, which is the initial amount that can be borrowed. The second was margin maintenance, which is the amount that must be maintained after stocks are purchased. The amounts are set by the Federal Reserve Board, as well as the brokerage firm. Individual brokerage firms can set stricter limits, but the Federal Reserve Board establishes minimum initial margin at 50% and margin maintenance at a minimum of 25%.
In a volatile market, prices can fall very quickly. If the equity (value of securities minus the amount borrowed from the brokerage firm) in your account falls below the margin maintenance level, the firm will issue a “margin call.” A margin call requires the investor to deposit more cash or face liquidation of the stock in the account.
For example, consider a purchase $20,000 worth of securities by borrowing $10,000 from the brokerage firm. If the market value of the securities drops to $15,000, the equity in the account falls to $5,000 ($15,000 -$10,000 = $5,000). Assuming a maintenance requirement of 25%, $3,750 must be maintained in the account (25% of $15,000 = $3,750). Thus, $5,000 worth of equity in the account is greater than the margin maintenance requirement of $3,750. Now, assuming the maintenance requirement is 40% instead of 25%. In this case, $5,000 in equity is less than the margin maintenance of $6,000 (40% of $15,000 = $6,000). As a result, the brokerage firm will issue a margin call.
If a margin call is not met, the brokerage firm has the right to sell securities in the account to increase equity above the margin maintenance level. In addition, the broker might not be required to consult the account owner before selling securities to meet the margin call. Under most margin agreements, a firm can sell securities without waiting for the account owner to deposit additional funds. In that case, the account owner might not be able to choose which securities to liquidate.
Because of this, it is imperative that you read your brokerage’s margin agreement very carefully before investing. This agreement explains the terms and conditions of the margin account, including: how interest is calculated, your responsibilities for repaying the loan and how the securities you purchase serve as collateral for the loan.
The Benefits of a Margin Account
The use margin is simply the employment of leverage. Just as companies borrow money to invest in projects, investors can borrow money and increase their investments. However, the use of leverage is sensible as long as the stock price is appreciating. If the right investment is chosen, margin can exponentially increase profits.
A 50% initial margin creates purchasing power of up to twice as much stock as compared to a conventional cash account. Therefore, one could make significantly more money by using a margin account than by trading from a pure cash position. The main concern is whether the stock price rises or not. Whether it is possible to consistently pick winning stocks is left up to the industry experts to debate. No matter the prevailing theory, margin does offer the opportunity to amplify returns.
The following is a demonstration of the power of leverage – an example that results in incredibly exaggerated profits:
Consider $20,000 worth of securities purchased using $10,000 of margin and $10,000 of cash. ABC Tequila Co. is trading at $100 and is projected to rise dramatically. Without margin, only 100 shares (100 x $100 = $10,000) can be purchased. However, 200 shares (200 x $100 = $20,000) can be purchased using margin.
ABC Tequila Co. then locks in Jennifer Lopez as a spokeswoman, and the price of shares skyrocket 25%. The investment is now worth $25,000 (200 shares x $125). After paying the $10,000 originally borrowed from the brokerage firm, what remains is $15,000, $5,000 of which is profit. That is a 50% return even though the stock only went up 25%. To keep the example simple, account commissions and interest charges were not included in the transaction. In reality, these costs would reduce profit.
The Risks of a Margin Account
Clearly, margin accounts are risky and not for all investors, as leverage is a double-edged sword, which can amplify losses and gains to the same degree. In fact, risk can be defined as the extent of swings in stock price. Because leverage amplifies these swings then, it can increase risk in an investment portfolio.
Returning to the ABC Tequila Co. example; say that instead of a 25% jump in share price, the share price fell 25%. The investment would be worth $15,000 (200 shares x $75). If the stock is sold and the brokerage firm is paid back $10,000, the end result is $5,000 in cash. That is a 50% loss plus commissions and interest. Losses can go beyond 50%, though. In fact, a fall of 50% or more will cause more than a 100% loss because of commissions and interest charges. Buying on margin is the only stock-based investment where an investor can lose more money than what was invested.
Cash accounts are ideal for investors expecting a stock price rebound. As long as the fundamentals of a company do not change for the worse, investors may want to hold and wait for a price recovery. Another benefit of a cash account is losses are unrealized or paper losses until a sale transaction is executed. This benefit is contrary to a margin account, which permits brokerage firms to sell securities if the stock price goes down. In that case, losses are locked in and participation in a possible future rebounds will be missed.
Inexperienced investors should stay away from margin investing. However, if one is compelled to attempt to profit using margin, only risk capital, or money that can be lost, should be used. The bottom line is: inexperienced investors are more likely to lose lots money if they invest on margin.