Buying on Margin – Definition

Cite this article as:"Buying on Margin – Definition," in The Business Professor, updated July 30, 2019, last accessed May 31, 2020, https://thebusinessprofessor.com/lesson/buying-on-margin-definition-2/.

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Buying on Margin Definition

Buying on margin refers to buying an asset by taking a leverage and borrowing the rest of amount from either a bank or broker. In simpler terms, it is the amount that a buyer pays upfront or in the initial stage to the broker at the time of making a purchase. For instance, the buyer will pay 10% upfront, and finance the remaining 90%. Marginable security acts as a collateral security for the amount borrowed. The investor who needs to use buying on margin approach, should get themselves approved, and create a margin account with their broker. The brokerage account exhibits the purchasing capacity for the total amount you spend using your cash and the feasible margin capacity. Besides buying on margin, short sellers of stock take advantage from their margin to borrow, and ultimately, make sale of shares.

Important takeaways:

  • Buying on margin refers to the amount that you borrow from someone, and then invest it somewhere.
  • It has its own pros and cons.
  • In case, the investor’s account drops beyond the maintenance margin, the broker has the right to sell a part or the whole of securities for helping the account reach its normal balance.

A Little More on What is Buying on Margin

In the U.S., the Federal Reserve Board decides on the extent of margin that needs to be borne by an investor for a security. As per 2019 regulations, an investor must fund at least half of the purchase price of a security through cash. And the half can be borrowed either from a broker or intermediary.

Just like it is with loans, you will need to pay the amount of money borrowed as well as interest thereon when you are buying securities on margin. Different brokerage institutions will have different interest rates for a given amount of loan. However, margin trades have lesser interest rates as compared to personal mortgage or credit cards. The borrower can be relieved from not having a specific deadline or timeline to repay. Instead, interest expenses for every month get accrued to the borrower’s brokerage account so that you can pay back the principal amount easily. Also, the margin interest falls in the tax-deductible category in case you plan to utilize the margin amount for investing in taxable securities pertaining to some restrictions.

While buying on margin, you must remember that you’re buying investments from that money borrowed. This approach naturally comes with some benefits as well as risks. If you buy securities, and there is a rise in their value, you’ll be receiving gains from somebody’s money indeed. However, with the reduction in the price of securities, the investor would be suffering losses.

How Buying On Margin Works

For seeing the working or functioning of buying on margin, and making it look simpler, we shall avoid the monthly interest expenses. The interest rates don’t create much of an impact on returns and losses as marginal principal does.

For instance, an investor invests in 100 shares of XYZ company for $50 per share. He manages to pay 50% of the purchase price ($2,500) using his own funds, and the remaining 50% with buying on margin. When the price of the share rises to $100, he can sell shares for a whopping amount of $10,000. From this amount, he can reimburse the broker with $2,500, which was the amount he borrowed in the initial stage. Considering the calculations, he managed earning $7,500 by investing one-third of the amount, $2,500. If he had purchased the similar number of shares by financing himself, then he would have earned $5,000 on his investment of $2,500.

Considering the downside, if the price of the share reduces from $50 to $25, the investor will incur a loss of $2,500. As the amount that he earned was equal to the amount he needed to pay to his broker, he won’t be earning anything on his investment. If he won’t have bought it on margin, he would have managed saving 50% of his investment, which is $1,250.

How to Buy on Margin

The broker or intermediary creates initial margin and maintenance margin by considering the credit history of the borrower, how quickly he/she can pay back the amount and the interest. These two types of margins must be there in the account prior to the investor uses buy on margin approach. Maintenance margin, as the name suggests, is the minimum amount that the investor must maintain before the intermediary or broker asks the investor to add more money.

For example, an individual invests in $10,000 with the maintenance margin being 50% ($5,000). When the equity starts falling below $5,000, the broker gives a margin call to the investor reminding him/her to maintain his balance at least to the maintenance margin. The investor can bring the balance back to said margin level either by adding more cash, or by selling off securities that he bought from the money borrowed. In case, he is unable to do so, the broker can start selling off his securities so as to bring maintenance margin to a certain amount.

Who Should Buy On Margin?

Buying on margin won’t be an appropriate trading strategy for newbies. It demands a specific tolerance to risk, and a lot of analysis. Fluctuations in the stock prices every now and then can be frustrating for many people. Investors use margin for buying commodity futures trading, while many securities including options contracts don’t fall under margin approach, and need to be bought in cash only. Trading in options or futures cannot be everyone’s cup of tea, but for most of the individual investors who prefer investing in stocks and bonds, buying on margin can bring an unwanted risk for them.

Reference for “Buying on Margin”

Academic Research on “Buying on Margin”

Buying on margin and short selling in an artificial double auction market Zhou, X., & Li, H. (2017).  Computational Economics, 1-17. Leverage trading, which consists of short selling and buying on margin, has been introduced into stock markets in many countries, including China. Ever since, there have been heated debates on how leverage trading influences financial markets. In this paper, an agent-based artificial market model is developed to simulate market behaviors and to analyze the influence of the leverage ratio on liquidity, volatility and price-discovery efficiency. In our artificial market, heterogeneous agents submit limit orders based on the fundamentalist or chartist strategy, and their effective supplies and demands can be increased by short selling or margin trading. Numerical analyses are performed in both one-sided and two-sided markets. We find that in one-sided markets, leverage trading can increase market liquidity and volatility, and decrease price-discovery efficiency. However, in the two-sided market, the increase of liquidity is much smaller, the volatility is decreased, and the price-discovery efficiency is improved. Generally, this model provides some meaningful results, which are supported by many other studies, and these findings underscore the necessity of building up a two-sided market when introducing leverage trading into stock markets.

Buying on margin, selling short in an agent-based market model, Zhang, T., & Li, H. (2013).  Physica A: Statistical Mechanics and its Applications392(18), 4075-4082. Credit trading, or leverage trading, which includes buying on margin and selling short, plays an important role in financial markets, where agents tend to increase their leverages for increased profits. This paper presents an agent-based asset market model to study the effect of the permissive leverage level on traders’ wealth and overall market indicators. In this model, heterogeneous agents can assume fundamental value-converging expectations or trend-persistence expectations, and their effective demands of assets depend both on demand willingness and wealth constraints, where leverage can relieve the wealth constraints to some extent. The asset market price is determined by a market maker, who watches the market excess demand, and is influenced by noise factors. By simulations, we examine market results for different leverage ratios. At the individual level, we focus on how the leverage ratio influences agents’ wealth accumulation. At the market level, we focus on how the leverage ratio influences changes in the asset price, volatility, and trading volume. Qualitatively, our model provides some meaningful results supported by empirical facts. More importantly, we find a continuous phase transition as we increase the leverage threshold, which may provide a further prospective of credit trading.

Margin regulation and stock market volatility, Hsieh, D. A., & Miller, M. H. (1990). The Journal of Finance45(1), 3-29. Using daily and monthly stock returns we find no convincing evidence that Federal Reserve margin requirements have served to dampen stock market volatility. The contrary conclusion, expressed in recent papers by Hardouvelis (1988ab), is traced to flaws in his test design. We do detect the expected negative relation between margin requirements and the amount of margin credit outstanding. We also confirm the recent finding by Schwert (1988) that changes in margin requirements by the Fed have tended to follow rather than lead changes in market volatility.

On the effectiveness of the federal reserve’s margin requirement, Luckett, D. G. (1982). On the effectiveness of the federal reserve’s margin requirement. The Journal of Finance37(3), 783-795. A portfolio‐theoretic model of the optimal margin account is developed. It is argued that the Federal Reserve’s goal in setting the margin requirement is to influence investor equity ratios. Using the average equity ratio as the dependent variable and the arguments of the model as independent variables, an empirical model is estimated. It is concluded that the margin requirement is an effective regulatory tool.

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