Buying On Margin Definition
Margin – is the sum of money that an investor borrows from their broker. This money is usually collateralized in some way by the assets and can only be used for investing and trading. That’s exactly what margin’s used for.
Buying on margin, therefore – is a practice of investing into assets using margin, a borrowed amount of money. It is considered an advanced trading strategy, considering that the investor takes on a debt that must be paid in the future, as well as agrees to pay additional funds as an interest.
It is, nevertheless, a very popular approach. Most legitimate brokers allow their clients to buy on margin, but the terms and conditions can vary from one provider to another. There are, however, common traits.
What do you need to buy on margin?
Marginal trading is a moderately demanding business. You need to keep several aspects in mind to be allowed to but on margin.
- You need to set up a margin account
Margin account is a special type of investing account that needs to be set up in addition to investor’s basic account. From here, you’ll be able to consider your options and view your loan and interest conditions.
Different brokers offer different terms on their loans, so you can set up several margin account on several platforms. Considering that you’ll be taking on a debt, you’ll have to make sure that potential terms fit your financial situation.
- You have to be creditworthy
As usual, in order to take on loans, you need an impeccable reputation as well as existing funds to back you up. Depending on a broker and a type of loan you’re borrowing, the threshold may vary. Large margins, of course, will require an astounding reputation.
How does it work exactly?
Margins are used to fund investments. American brokers allow investors to fund only 50% of any purchase with margin, by law. It means that if you plan to buy a large share supply worth, say, $10000, you’ll only be able to use $5000 from your margin account. Given, you’re borrowing from a broker who follows such rules.
So, a possible 50% portion of the investments must come from your own pocket. That’s a nuance number #1.
Furthermore, the margin sum itself is composed of two major types of margin funds: initial margin and maintenance margin. Investors can do whatever they wish with the initial margin, it is a bulk of the loan.
However, the maintenance margin is there to ensure the investor is solvent at any given time. If the investor is currently in the middle of an open position (currently investing), the maintenance margin should remain untouched. If it doesn’t, an investor is bound to compensate the losses or risk having their investments sold for compensation. That’s the nuance #2.
Moreover, the maintenance usually composes a portion of your whole margin. So, if you want to actively buy $10000 of assets on margin, $5000 will have to be funded from your own wallet. Therefore, only $5000 of actual margin can be borrowed by you for this deal.
But if you’re obliged to keep 50% (as set by the broker) of the margin untouched as maintenance, you’ll have to instead borrow $7500 of margin to be able to invest $5000. Again, maintenance is out-of-bounds for investing. If you can only use 50% of the margin, it must be bigger than you intended. If you only borrow $5000, then the initial margin would be $2500.
Interest
Interest is always a part of any margin. Most of the time, margin trading has to be short-term, but the interest rate can also favor the long-term investing. The rate can be flexible, but it’s a double-edged sword in essence. Some brokers may offer you favorable rates for specific assets, but they may also change it whenever they please.
You are highly advised to read the terms and conditions properly and know what the broker authorizes themselves to do with your loan.
What can margin be used for?
Margin is very helpful in situations when an investor needs additional funds to multiple their potential profits from a reliable source.
Example
An investor knows that the stock of company N is going to rise in value exponentially. This pushes them to buy the stock on margin when it’s still cheap and costs $5000. Half is invested by the investor, while the other half is borrowed from a broker (a margin).
The prices of stock skyrocket and triple. Now the shares cost $15000 and the investor successfully sells them at a market price. While the value of shares increased, the loan did not. It’s still worth $2500 (minus the interest) and the investor returns the margin in good faith.
The result: if the investor only used their own money, they would’ve invested $2500 and the profits would be $7500. Granted, there wouldn’t be any need to return the margin, but even after return expenses, the investor is left with $12500.
The maintenance was not counted. If case of a successful investment, you may as well ignore it. But if things go south and you lose 100% of your margin, including the maintenance, you’ll have to return even more money, obviously. So it’s best to not touch the maintenance at all.
Short trading
Short trading – is a well-known kind of margin trading. While selling short, however, the ideal outcome is antithetic. You don’t wait until the peak of price, you wait for it to hit rock bottom. Why would you do so?
Well, short selling is different in two fundamental ways.
- Borrowing in stock
While short selling, you don’t borrow the money collateralized in stock, you borrow the stock itself. Then you immediately sell them and keep the money.
- Full margin investing
While basic buying on margin compels you to dilute the investments pool with your own funds, all short purchases are made exclusively in borrowed shares.
The process is simple. You borrow the assets, sell them, wait until the price on the same asset drops, but them back for the smaller price, and then return them. As a result, you’re left with either some stock of your own or the portion of the money that came from the initial sale.
Summary
Don’t try any sort of margin trading if you aren’t prepared for a risk or if aren’t confident enough in the deal you’re trying to conduct.
Buying on margin is immensely risky. While the profits are exponentially larger with practically no expenses, the losses can multiple just as well.
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