Margin is an investing tool that every investor should know about and understand. In a nutshell, margin is money that you borrow from your broker to buy extra stocks. Today, using margin to buy stocks requires a special account with a brokerage firm and is commonly referred to as the “marginal account”. When you decide to buy some stock, you may use your allowed margin to purchase more shares than you can pay for. This technique allows you to increase your earnings on investment, but can also cause you to lose more than you normally would. Because of this risk, only certain stocks are allowed to be bought on margin. To be more specific, usually stocks with prices below $5, IPOs, and certain NASDAQ stocks are not marginable due to their high risk factors and their high volatility. Stocks that can be purchased on margin are referred to as “marginable securities”.
Because of its risky nature, margin is strictly regulated by the Federal Reserve Board. After the crash of 1929, where the market dropped tremendously due to being saturated with marginal investments, policies on marginal trading have become very strict. Currently, the law only allows you to borrow up to 50% of the value of your marginable securities. This means that you, as an investor, have to pay at least one half of the cost of your stocks, which allows you to double your buying power. Let’s suppose that you have $10,000 and would like to buy stock of a company that is currently valued at $100 per share. Normally, you would only be able to buy 100 shares (10000/100), but with a marginal account, you are able to buy 200 shares, paying $10,000 and borrowing the other $10,000 from your broker. Let’s suppose that these shares go up to $110 per share when you decide to sell. If you had bough the 100 shares, without the margin, you would get $11000 (100*$110), making $1000, or 10% on your initial investment of $10,000. However, with a marginal account you would get back $22,000 (200*$110) and make a total of $2,000 (remember, the $10,000 goes back to your broker), meaning that you’d get a 20% return on your initial investment of $10,000.
As you can see, margin can be used as a powerful tool in the hands of a skilled investor, but there is also a down side to this. Suppose that the stock that you bought at $100 per share goes down to $90 per share. Now, you’d normally sell for $9,000, losing $1000. However, if you use your margin you will sell for $18,000, pay the $10,000 loan back to your broker, and lose $2,000!
Aside from the potential of doubling your losses, marginal accounts almost always include additional fees. Many firms charge % on your borrowed money, and certain brokerage firms charge higher commission and monthly fees on the marginal accounts. Also, there is another catch to marginal accounts, something that is referred to as the “margin call”. If your stock drops low enough, which usually means below 30% of the amount loaned to you, your broker may require you to put up additional collateral to bring the lost amount above the minimum (30% usually). If you do not do this in time, your broker will proceed to sell shares of your stock for you to get above the minimum. If this selling occurs and the stocks still do not cover the loan, you are left in debt. For example, if you buy the 200 shares of stock at $100 per share, and then the shares drop to $65, your portfolio value will be $13,000. Remember that the $10,000 of that money is your broker’s, meaning that you only have $3,000, or 30% of the loan. If the price of your stock drops any lower you will get a margin call from your broker requiring you to put up additional collateral, either in form of cash or other marginable securities (not necessarily the ones you purchased), but only a percentage of the market value of a security can be used to meet your margin call. If, for whatever reason, you are unable to meet the 30% requirement, your broker has the right to sell off enough of your margined shares to cover the loan.
Hopefully this has opened your eyes to some of the risks involved in marginal trading. After all, you are playing with somebody else’s money, and that always means great risk. However, if you have done all your homework and are quite positive about the future of your investment, it is usually a good idea to increase your gains through marginal buying. As a final thought, I’d like to point out that many investors suggest borrowing no more than 20% of your portfolio to avoid getting burned and losing your savings. Remember, pigs always get slaughtered in the end!