Why Is Buying Stocks on Margin Considered Risky?

Buying on margin involves borrowing money from a broker to purchase stock. A margin account increases purchasing power and allows investors to use someone else's money to increase financial leverage. Margin trading offers greater profit potential than traditional trading but also greater risks.

Purchasing stocks on margin amplifies the effects of losses. Additionally, the broker may issue a margin call, which requires you to liquidate your position in a stock or front more capital to keep your investment.

Key Takeaways

  • Buying stocks on margin involves borrowing money from a broker to purchase securities or stock shares.
  • Investors use leverage when trading on margin to increase their position size beyond what they could usually afford with cash.
  • Margin trading is risky since the margin loan needs to be repaid to the broker regardless of whether the investment has a gain or loss.
  • Buying on margin can magnify gains, but leverage can also exacerbate losses.
  • A margin call can be issued if the account market value declines by too much, requiring investors to sell their shares or deposit more cash.

How Buying Stocks on Margin Works

Typically, when are investor buys a stock, cash is debited from their brokerage account to pay for the purchase. The cash amount secures 100% of the purchase amount of the stock based on the stock price and the number of shares purchased.

Margin trading involves borrowing money from a broker and using that money to purchase securities or equity shares. By taking out a loan, the investor can buy more shares than they would have otherwise been able to afford using only the cash in their account. In return, the investor must repay the loan plus the interest that the broker charges.

Margin trading involves establishing a margin account, which is different than the typical cash account held at a brokerage firm. The securities or stocks held in the margin account act as collateral for the margin loan. However, not all securities can be purchased on margin.

Minimum Margin

Before trading on margin, investors are required to have a minimum margin deposit with their brokerage firm of $2,000 or 100% of the purchase price, whichever is less. However, some firms may require more than $2,000 to be deposited as the minimum margin.

Initial Margin

Before initiating the first trade on margin, the Federal Reserve limits how much can be borrowed on margin for the initial trade—called the initial margin. A brokerage firm can lend a customer up to 50% of the total purchase price of a stock for a new purchase. In other words, if a broker lent 50% of the purchase price, you must deposit the other 50%. However, some brokerage firms may require more than 50% of the purchase price for the initial trade.

Margin History

It is worth remembering that during the boom known as the "Roaring Twenties" just before the great Stock Market Crash of 1929, margin requirements were just 10%. That meant that the same $10,000 balance in the account could allow for the purchase of $100,000 worth of stocks.

As a result, the 10% requirement led to rampant speculation, increasing leverage dramatically, and when the market crashed, many investors that used margin were wiped out. As a result, margin investing was frowned upon, and some Federal Reserve Board believed speculating on stocks diverted resources from productive uses like commerce.

When buying stocks on margin, whether there's a gain or loss on the investment, you're still required to pay back the margin loan to the broker.

Example of Buying Stocks on Margin

Suppose you have $10,000 in your margin account but want to buy a stock that costs more than that. Due to the 50% initial margin requirement, you must have 50% in cash for a stock purchase. As a result, you can purchase up to $20,000 worth of stock, effectively doubling your purchasing power.

Scenario 1: The Stock Price Rises

After you make the purchase, you own $20,000 in stock, owe the broker $10,000, and the value of the stock serves as collateral for the loan. Outlined below shows the scenario had the stock's price increased in value.

  • Own $20,000 stock position; $10,000 financed via margin loan and $10,000 via cash
  • Stock price moves higher; new market value = $30,000
  • Sell the stock position for $30,000
  • Payoff the $10,000 loan (plus any interest)
  • Account cash balance = $20,000 (excluding interest and fees from the loan)

The balance of $20,000 (minus interest charges) means the investor earned a 100% gain on the initial $10,000 cash investment. Had you initially paid for the entire $20,000 with cash (no margin loan) and sold at $30,000, the gain would be only 50%. This scenario illustrates how using leverage by purchasing on margin can amplify gains.

Scenario 2: The Stock Price Falls

Leverage can amplify losses in the same manner. Let's assume the same stock position but instead, the stock price declines.

  • Own $20,000 stock position; $10,000 financed via margin loan and $10,000 via cash
  • Stock price declines; new market value = $15,000
  • Sell the stock position for $15,000
  • Payoff the $10,000 loan (plus any interest)
  • Account cash balance = $5,000 (excluding interest and fees from the loan)

After paying your broker the $10,000 owed for the loan, your cash balance is now $5,000. In other words, you lost 50% of the initial $10,000 cash investment. However, the stock's market value declined by only 25%, from $20,000 to $15,000.

Just as you doubled your gains in scenario one when the stock price increased, you doubled your losses in scenario two when the stock price declined.

By borrowing on margin, investors use leverage to increase their purchasing power and magnify gains. However, margin trading can also magnify losses if the stock or security declines in value.

Why Buying Stocks on Margin Can Be Risky

Although investing has inherent risks associated with it that can include losing some or all of your initial investment, margin trading can exacerbate those risks.

Maintainence Margin

Once you've purchased a stock or security on margin, you're required to keep a minimum amount of equity in your margin account. Equity is the market value of the securities in the account minus the margin loan amount. At a minimum, investors must have at least 25% of the total market value of the securities as required by the Financial Industry Regulatory Authority (FINRA).

This maintenance margin requirement can vary between brokers and be as high as 30% to 40%, depending on the type of securities being purchased. Although the maintenance margin of 25% is not risky in itself, it's when the securities decline in value to the extent the requirement is breached that investors can get into financial difficulty.

Margin Calls

If the value of your stock decreases, causing your equity to fall below the 25% maintenance margin, you may receive a margin call. A margin call requires investors to increase the equity in the account by liquidating stock or depositing additional cash.

Returning to the example above, let's say that your broker's maintenance margin requirement is 40% versus the 25% FINRA requirement.

  • You borrowed $10,000 on margin and purchased $20,000 in stock.
  • If the stock price declines, causing the market value to decline from $20,000 to $15,000, your equity has decreased to $5,000.
  • Remember, equity is the value of the securities in the account minus the margin loan or ($15,000 - $10,000 = $5,000 in equity).
  • The equity amount of $5,000 is only 33% of the market value (or $5,000 / $15,000), which is below the 40% minimum.

If you cannot or choose not to contribute more money to cover the margin call, your broker is entitled to sell your stock and does not need your consent.

What Does It Mean to Buy Stocks on Margin?

Buying stocks on margin means investors are borrowing money from their broker to purchase stock shares. The margin loan increases buying power, allowing investors to buy more shares than they would have been able to, using only their cash balance.

How Does Buying Stocks on Margin Work?

To buy stocks on margin, a margin account must be opened and approval obtained for the loan. If the stock's price rises, the investor can sell the stock, repay the loan, and keep the profit. If the stock's price falls, the broker may issue a margin call, requiring more cash or selling the stock. The loan must be repaid regardless of whether the stock rises or falls.

Is Margin Trading Good for Beginners?

Buying stocks on margin is not for beginner investors. It's important to understand the risks and that the margin loan doesn't exceed the investor's ability to repay the loan.

Article Sources
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  1. U.S. Securities and Exchange Commission. "Margin: Borrowing Money to Pay for Stocks."

  2. Electronic Code of Federal Regulations. "Part 220—Credit by Brokers and Dealers (Regulation T): §220.12  Supplement: Margin Requirements."

  3. Federal Reserve History. "Stock Market Crash of 1929."

  4. Financial Industry Regulatory Authority. "4210. Margin Requirements, (c) Maintenance Margin."

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