Margin buying allows investors to spend more money than they have by borrowing from brokers. It can lead to high returns, but also devastating losses. Margin requirements have increased since the 1920s to prevent weak investment positions and market crashes. The NYSE requires a $2,000 deposit and limits borrowing to 50% of the investment value.
Buying on margin is a way to spend more money than you actually have available for an investment. This is done by placing a smaller investment as collateral and then borrowing money from the broker to offset the rest of the cost of the stock. Margin buying can be an excellent way to make a lot of money from a relatively small amount of start-up capital, but it can also result in some pretty devastating losses. Let’s look at an example to see how buying on margin can produce big benefits and also to understand the downsides.
Imagine buying a stock for $100 and buying it all with our own money. The share price then doubles, leaving our stock worth $200. We have just made a 100% return on our initial investment and a profit of $100.
Now imagine we only have $25, so we buy $100 worth of stock using margin buying, with a $75 loan from our broker. The stock price doubles to $200, so our return is actually 700%, minus the $75 plus interest we owe our broker. So, with an initial investment of $25, we made nearly $100, or nearly quadruple our initial investment. So margin buying can be a wonderful shortcut to great returns.
On the other hand, imagine a similar margin buying scenario. We’re buying $100 worth of stock, all with our own money. The price collapses to half of its initial value, closing at just $50. We have now lost 50% of our initial investment, a major blow, sure, but one that still leaves us with some capital to invest.
Imagine instead that we only have $25, so we buy $100 worth of stock using margin buying with a loan from our broker. When the share price falls below our initial investment, our broker will issue a margin call, requiring us to pay more to meet the minimum margin requirement. Otherwise they will sell our stock to cover the loan and we will be left with nothing.
Even if we pay another $25 to cover the minimum margin, as the stock price falls to $50, we’re still left with nothing. Out of our initial investment we have completely lost 100%, leaving us with nothing. So margin buying can be a dangerous path if the market is having a bad day or our stock picks are unfortunate.
Margin buying has changed since the 1920s when it had relatively loose regulations and minimum margin requirements were very low. This situation led to many weak investment positions, which in turn helped usher in the Crash of 1929 and the Great Depression. Since then, brokers have tended to require higher minimum margins when buying margin, asking investors to invest more upfront capital to protect them from market fluctuations. The Federal Reserve Board now has a set of rules governing margin buying, and self-regulating organizations, such as the NASD and NYSE, have their own rules. These include things like a minimum margin requirement: The New York Stock Exchange requires at least a $2,000 deposit with the brokerage and a limit on leverage, limiting you from borrowing more than 50% of the total investment value.
Smart Asset.
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