Understanding Margin –
Margin is borrowing money from your broker to buy a security and using your investment as collateral. Investors generally use margin to increase their purchasing power so that they can own more securities without fully paying for it. The amount owed to the broker is called the debit balance. Through the use of leverage, investors attempt to magnify gains on actual cash or collateral deposited into their accounts. But at the same time, the use oft margin exposes investors to the potential for higher losses. Another reason for borrowing money from brokers is the feature involving a no-repayment-date loan. This feature is generally not available through other types of lending institutions, including banks. The no-repayment feature, although very attractive, can be fraught with danger. The investor should be made aware that if the value of securities on deposit with the broker declines substantially, the broker will require additional funds or collateral to protect the loan.
There are 2 primary types of margin requirements: initial and maintenance.
Initial/Reg T requirements:
An initial margin requirement is the amount of funds required to satisfy a purchase or short sale of a security in a margin account. The initial margin requirement is currently 50% of the purchase price for most securities, and it is known as the Reg T or the Fed requirement, which is set by the Federal Reserve Board. In addition, most firms have minimum requirements that must be met when initially opening a margin position, which may vary from firm to firm.
Ongoing margin requirements after the purchase is complete are known as maintenance requirements, which require that you maintain a certain level of equity in your margin account. Maintenance requirements are set by the NYSE, FINRA, and/or the brokerage firm.
Understand How Margin Works:
Let’s say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you’ll earn a 50 percent return on your investment. But if you bought the stock on margin – paying $25 in cash and borrowing $25 from your broker – you’ll earn a 100 percent return on the money you invested. Of course, you’ll still owe your firm $25 plus interest.
The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let’s say the stock you bought for $50 falls to $25. If you fully paid for the stock, you’ll lose 50 percent of your money. But if you bought on margin, you’ll lose 100 percent, and you still must come up with the interest you owe on the loan.
In volatile markets, investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls. Some investors have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin – without any notification and potentially at a substantial loss to the investor. If your broker sells your stock after the price has plummeted, then you’ve lost out on the chance to recoup your losses if the market bounces back.
Who Should Use Margin:
Investors who generally use margin are those who are aggressive and who fully understand the risks as well as rewards in using leverage. Conservative investors for the most part shy away from the use of margin because of the risks associated with its use. Some of these risks are set forth below.
Margin accounts can be very risky and they are not suitable for everyone. Before opening a margin account, you should fully understand that:
- You can lose more money than you have invested;
- You may have to deposit additional cash or securities in your account on short notice to cover market losses;
- You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
- Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.
You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines. Know that your firm charges you interest for borrowing money and how that will affect the total return on your investments. Be sure to ask your broker whether it makes sense for you to trade on margin in light of your financial resources, investment objectives, and tolerance for risk. Importantly, read the margin agreement and make sure that you understand all of its terms.
Please keep in mind that this information is being provided for educational purposes. It is not designed to be complete in all material respects. If you have any questions relative to the contents of this post you should contact a qualified professional.
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