To continue on with my buying and selling stocks for beginners series, lets get into the basics of how stock margin and margin accounts work.
When the application to open a discount brokerage account is initiated, there is a choice of whether to open a margin or cash account. I typically open a margin account because, one, I understand how it works (for the most part), and second, it’s the same as a cash account except that you have the “option” of borrowing from the brokerage. The ability to borrow from the brokerage also opens the door to shorting a stock and buying/selling options if the investor chooses.
How does a margin account work?
Margin accounts are identical to cash only accounts except that they have the ability to go into a negative balance. Once the account goes into the negative range, the brokerage will charge you interest at their margin rates.
Some of the more trader friendly discount brokerages, like Interactive Brokers, have margin rates below prime which makes it an ideal choice for leveraged equity investing.
How does buying stock on margin work?
The term margin represents the investors equity in the trade. When we say that 50% of the stock is marginable, that basically represents that the investor needs at least 50% equity in the trade.
Not every stock on the market is available to be purchased on margin. For equities, the trader can typically margin up to 50% of the total value of the trade providing that the stock is above $2 and is a marginable security. Securities that are less than $2 in value have a higher margin requirement.
Some of the larger, higher volume stocks on the exchange are eligible for reduced margin (30%) which means that the investor can borrow up to 70%. Here’s a list of securities eligible for reduced margin as indicated by Interactive Brokers.
- Share Price: $10 (assume eligible for reduced margin)
- Purchase Amount: $10 x 100 shares = $1000
- 30% margin = $300 minimum equity required and maintained, $700 borrowed.
- Interest rate = 5%
Case 1 – The Ideal Situation: After 1 year, shares rise to $12 and sold
- Value: $12 x 100 shares = $1200
- – purchase cost ($1000) – interest cost incurred ($35) = $165 profit
- 55% gain with margin/leverage, 20% gain without.
Case 2 – The Dreaded Margin Call: After 1 year, shares drop to $8
- Value: $8 x 100 shares = $800
- $800 – borrowed amount ($700) = $100 which is $200 less than the $300 (equity) required to be maintained. This will result in a margin call (see below) which will require $200 to be deposited into the account immediately. The choice is either to sell the security or deposit the minimum of $200.
As you can see from Case 2, there was a margin call. Margin calls occur when margin is used and the investment value falls below the margin requirement. When this happens, there is one of two things that has to happen to get the account back to acceptable levels.
- The investor can deposit cash into the account to eliminate the deficit.
- If the cash does not arrive within the specified time indicated by the brokerage, then the brokerage has the right to liquidate securities until they get their money back.
Margin is simply a fancy word for leverage. However, borrowing with margin is different than using a loan or line of credit to invest with. First, the money is borrowed directly from the brokerage and second, if the investments purchased with margin decrease in value, the brokerage has the right to sell those securities without warning (margin call).
To avoid the dreaded margin call, one strategy is to borrow much less than the maximum borrowed amount permitted. That way, when the markets become volatile, there will be some buffer before the margin requirements come knocking, which will help avoid selling stocks low.
Final note, as you can see with the examples above, investing with leverage amplifies both winners and losers. Do you own due diligence before using leverage to invest.