Buying a stock on margin is essentially using credit to purchase stock shares, much like using a credit card. A brokerage firm lends money to an investor to buy stocks. The brokerage firm will charge interest on the money it lends. The Federal Reserve Board has placed limits on margin buying. Currently the initial margin requirement (the required equity position to enter into a margin transaction) is 50%, meaning the investor must provide at least 50% of the amount of funds needed to enter into the trade. The brokerage firm will provide the remainder of the funds. The brokerage firm will then hold the securities that are bought as collateral.
If the stock goes up after it is purchased, the investor's profit will be magnified given the stocks purchased on margin. However, if the stock goes down, the losses are then magnified.
Example: Determine the return on a margin trade
Assume that an investor purchased 500 shares of Newco's stock. The shares were trading at $50 when the transaction was executed. Assume the investor was able to sell the shares for $100. To determine the effect of the leverage with purchasing the shares on margin, compute the return on the transaction if (1) no margin was used and (2) 70% initial margin requirement was used. Assume no transaction costs.
1) No margin was used
If no margin was used, the initial cash outlay for the shares was $25,000 (500 shares at $50). The investor then sold the shares for $50,000 (500 shares at $100).
The return on the trade was thus ($50,000/$25,000) - 1 = 100%.
2) 70% initial margin requirement
Given the initial margin requirement of 70%, the investor would need an initial cash outlay of $17,500 ($25,000 x 70%). The investor borrowed $7,500 ($25,000 x 30%) from the brokerage firm to complete the transaction.
The investor was then able to sell the shares for $50,000 (500 shares at $100). The investor then repays the amount borrowed of $7,500 and the remaining position would be equal to $42,500 ($50,000 - $7,500).
The return on the trade was thus ($42,500/$17,500) - 1 = 142.9%.
As shown in the examples above, the investor was able to magnify his returns by buying stock on margin.
What is Maintenance Margin?
A maintenance margin is the required amount of securities an investor must hold in his account if he either purchases shares on margin, or if he sells shares short. If an investor's margin balance falls below the set maintenance margin, the investor would then need to contribute additional funds to the account or liquidate stocks in the account to bring the account back to the initial margin requirement. This request is known as a margin call.
As discussed previously, the Federal Reserve Board sets the initial margin requirement (currently at 50%). The Federal Reserve Board also sets the maintenance margin. The maintenance margin, the amount of equity an investor needs to hold in his account if he buys stock on margin or sells shares short, is 25%. Keep in mind, however, that this 25% level is the minimum level set, brokerage firms can increase, but not decrease this level as they desire.
Example: Determining when a margin call would occur.
Assume that an investor had purchased 500 shares of Newco's stock. The shares were trading at $50 when the transaction was executed. The initial margin requirement on the account was 70% and the maintenance margin is 30%. Assume no transaction costs. Determine the price at which the investor will receive a margin call.
Calculate the price as follows:
$50 (1- 0.70) = $21.43
1 - 0.30
A margin call would be received when the price of Newco's stock fell below $21.43 per share. At that time, the investor would either need to deposit additional funds or liquidate shares to satisfy the initial margin requirement.
Effects of the Institutionalization of capital markets
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