What is 'Buying On Margin'
Buying on margin is the purchase of an asset by paying the margin and borrowing the balance from a bank or broker. Buying on margin refers to the initial or down payment made to the broker for the asset being purchased; the collateral for the borrowed funds is the marginable securities in the investor's account. Before buying on margin, an investor needs to open a margin account with the broker.
BREAKING DOWN 'Buying On Margin'In the United States, the Federal Reserve Board regulates the amount of margin that an investor must pay for a security. As of 2016, the Federal Reserve Board requires an investor to fund at least 50% of a security's purchase price with cash. The investor may borrow the remaining 50% from a broker or a dealer.
How to Buy on Margin
Based on creditworthiness and other factors, the broker sets the minimum or initial margin and the maintenance margin that must exist in the account before the investor can begin buying on margin. Maintenance margin refers to the minimum amount of money that must exist in the account before the broker forces the investor to deposit more money.
Suppose an investor deposits $10,000 and the maintenance margin is 50%, or $5,000. As soon as the investor's equity dips even a dollar below $5,000, the investor may receive a margin call. When this happens, the broker calls the investor and demands that the investor bring his balance back to the required maintenance margin level. The investor can do this by depositing additional cash into his brokerage account or by selling securities that he purchased with borrowed money.
Buying on Margin Benefits and Risks
Buying on margin offers investors some definite benefits, but the practice is also fraught with risk. Using this kind of leverage to purchase securities with someone else's money amplifies gains when the value of those securities increases, but it magnifies losses when the securities decline in value.
Consider an investor who purchases 100 shares of Company XYZ stock at $50 per share. He funds half of the purchase price with his own money and the other half he buys on margin, making his initial cash outlay $2,500. After a year, the share price doubles to $100. The investor sells his shares for $10,000 and pays back his broker the $2,500 he borrowed for the initial purchase. Ultimately, he triples his money, making $7,500 on a $2,500 investment. Had he purchased the same number of shares outright using his own money, he would only have doubled his money, from $5,000 to $10,000.
Now consider that instead of doubling after a year, the share price falls by half, to $25. The investor sells at a loss and receives $2,500. Since this equals the amount he owes his broker, he loses 100% of his investment on the deal. Had he not used margin to make his initial investment, he still would have lost money, but he would only have lost 50% of his investment.