Definition
Buying on margin refers to the process of purchasing securities using money borrowed from a broker. This is facilitated through a margin account, which allows investors to buy more securities than they could with just their available cash. The practice of buying on margin is strictly regulated by the Federal Reserve Board (FRB) to help maintain the stability of the financial markets.
Examples
- Stock Purchase: An investor wants to buy $10,000 worth of stocks but only has $5,000. By opening a margin account with a broker, the investor can borrow the remaining $5,000 and purchase the stocks.
- Leveraging Investments: An investor anticipates a short-term increase in a stock’s price. By buying on margin, they can amplify their potential gains (though also their potential losses) by using more capital than they have on hand.
Frequently Asked Questions (FAQs)
What is a Margin Account?
A margin account is a brokerage account that allows investors to borrow money from the broker to purchase securities. The investor uses the purchased securities as collateral.
What are the risks of buying on margin?
The primary risks include the potential for amplified losses if the value of the securities declines and the requirement to meet margin calls, which can force the investor to sell securities at unfavorable prices.
How much can an investor borrow in a margin account?
The Federal Reserve Board sets initial margin requirements, and brokers may have their own margin policies. Typically, investors can borrow up to 50% of the purchase price of securities.
What happens if the value of the securities falls?
If the value of the securities falls below a certain level, maintenance margin requirements kick in, and the broker may issue a margin call, requiring the investor to deposit more cash or sell some assets.
Are all securities marginable?
No, not all securities are marginable. Brokers provide lists of eligible securities, and high-risk or low-liquidity securities are often excluded.
Related Terms
- Margin: The difference between the loan amount and the total value of the securities purchased. It represents the equity that the investor has in their margin account.
- Margin Call: A broker’s demand that an investor deposit additional money or securities into the margin account to meet the minimum maintenance margin.
- Leverage: The use of borrowed capital to increase the potential return of an investment. This practice can amplify both gains and losses.
- Initial Margin Requirement: The percentage of the purchase price of securities that the investor must pay for with their own funds when buying on margin, as mandated by the Federal Reserve Board.
Online References
Suggested Books for Further Studies
- “Understanding Wall Street” by Jeffrey B. Little and Lucien Rhodes
- “The Intelligent Investor” by Benjamin Graham
- “One Up on Wall Street” by Peter Lynch
- “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” by Seth A. Klarman
Fundamentals of Buying on Margin: Investment Basics Quiz
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