Should Beginning Investors ever Buy a Stock on Margin

What is Margin?

“Margin” is borrowed money that is used to purchase stock, or other securities. When an investor uses margin for a purchase, they are “buying on margin.” The purchaser uses some of their own money, in combination with funds borrowed from a broker, to purchase more stock than they could otherwise afford. There are several important terms to understand when discussing margin investing:

*Initial Margin*

The ratio of investor money to borrowed money at the time of purchase. The Federal Reserve regulates the allowable initial margin under Regulation T. Currently the maximum initial margin is 50%, meaning to purchase $100, the investor must use at least $50 of their own money. Regulation T also requires that margin accounts must contain at least $2000 in cash or securities. Some brokerages require higher levels.

*Maintenance Margin*

The minimum amount of investor equity that must be maintained in a margin account. For the New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority (FINRA), the minimum is 25%, meaning that at least $25 of every $100 in the margin account must be the investor’s own funds. This can be expressed in the equation

(Current Value – Amount Borrowed)/Current Value >= 0.25

*Margin Call*

A requirement from a broker to add funds to a margin account to satisfy the required maintenance margin. For example, if an investor purchased $100 of stock with $50 of their own equity and $50 of margin and the value of the stock fell below $66.66, the broker would require additional funds be added to the account, or some shares would be sold. This can happen at any time, not just at the end of the day. Many margin agreements allow brokerages to sell securities without additional notification to meet a margin call.

Is Margin Right For Beginning Investors?

Buying stock on margin allows investors to magnify their gains. By borrowing money, an investor can control more stock than they otherwise would be able to, resulting in greater profits when the stock rises. Consider an investor with $100. If he buys $100 of stock and the stock rises 10%, his holdings are now worth $110, and he has gained 10% (neglecting any fees for buying or selling). However, if he uses a margin account, he can use his $100 together with another borrowed $100 to purchase $200 of stock. When that stock rises the same 10%, his holdings are now worth $220, a 20% profit on his $100 investment.

Of course, there is no such thing as a free lunch. Buying on margin magnifies gains, but it will also magnify losses. The brokerage doesn’t loan money for free, and expects to be paid back regardless of investment returns. Interest is charged on margin balances, eating in to profits and turning “unchanged” into a loss. Interest rates vary, E*trade currently charges between 8.44% and 3.389%, depending on account balance. This means an investment with an annual return of 7% (pretty good these days) would actually lose money if purchased using margin at 8.44%. Interest costs make buying on margin a generally short-term proposition. The longer the stock is held, the more the interest accumulates and makes turning a profit increasingly difficult.

Worse than paying interest, the full margin must be repaid to the brokerage, regardless of the actual performance of the stock. Let’s say that our imaginary investor buys another $200 of stock using $100 of margin and $100 of his own equity. This time, rather than going up, the stock drops 20%. If he had used just his own money, he would lose $20 of his $100, and have $80 left. However, since he used margin, the $200 investment is now worth $160. The $40 loss is subtracted entirely from his equity, so he would get back $60 after selling and repaying the $100 margin loan, doubling his losses. If the stock fell more than 50%, our investor would actually lose more than his original investment, as his equity would be wiped out, and he would still need to repay the full margin loan, plus interest and fees. And remember, when our investors equity drops below the required maintenance margin, the brokerage can sell securities to meet the requirement, locking in losses even if the stock later rebounds!

This magnification of risk generally makes buying on margin a bad idea for beginning investors. Buying on margin is an advanced trading strategy that requires advanced trading knowledge and a willingness to risk losing every dollar invested. Sophisticated investors are better able to mitigate risk through hedging and comprehensive understanding of markets and how to profit from them. Sophisticated investors also fully understand and accept the risks of buying on margin. Beginning investors, almost by definition, don’t have the knowledge or understanding to appreciate the risks of margin investing or take advantage of its benefits.