Margin buying allows investors to borrow money from brokers to invest more than they have on hand, potentially leading to high profits or devastating losses. Regulations have increased since the 1920s to protect against market fluctuations, including minimum margin requirements and limits on leverage.
Margin buying is a way to spend more money than one actually has on hand on 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 a great way to make a lot of money with a relatively small amount of start-up capital, but it can also lead to some pretty devastating losses. Let’s look at an example to see how margin buying can generate great benefits and also to understand its drawbacks.
Imagine that we are buying a stock for $100, and that we are buying everything with our own money. The stock price then doubles, leaving our shares 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 by buying on margin, borrowing $75 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’ve made almost $100, or nearly quadrupled our initial investment. Therefore, margin buying can be a wonderful shortcut to reaping huge profits.
On the other hand, imagine a similar margin buying scenario. We are buying $100 worth of stock, all with our own money. The price falls to half of its initial value, closing at just $50. We have now lost 50% of our initial investment, a heavy blow to be sure, but still leaving us some capital to invest.
Imagine instead that we only have $25, so we buy $100 worth of stock by buying on margin with a loan from our broker. As 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 securities to cover the loan and we will have nothing left.
Even if we pay another $25 to cover the minimum margin, as the stock price falls to $50, we’ll still be left with nothing. Outside of our initial investment, we have completely lost 100%, leaving us with nothing. Therefore, margin buying can be a dangerous path to take if the market has a bad day or our stock choices are unlucky.
Margin buying has changed since the 1920s, when it had relatively lax regulations and very low minimum margin requirements. 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 in cases of margin buying, asking investors to put up more seed capital to help protect them against fluctuations in the market. The Federal Reserve Board now has a set of rules that handle margin buying, and self-regulatory organizations like 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 US$2,000 deposit with the brokerage, and a limit on leverage, which limits you to borrowing more than 50% of the total value of the investment. .
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