What is Margin?
Margin is the difference between what money a person has on their own and what that same person owes.
Buying on margin then, refers to money that has been borrowed from a broker whose intended use is to make an investment, such as the purchase of a stock.
Buying on Margin Benefits
The primary benefit of buying on margin is that it allows an investor to purchase more stock than they would have been able to on their own.
Buying on Margin Drawbacks
The primary drawback of buying on margin is that it increases the amount of risk that is already present in stock trading.
With a loan, comes an interest rate and some form of collateral.
In this case, that collateral is the stock purchased with the loan.
As a result, the effect of both gains and losses are exaggerated when buying on margin.
So even though more stock may be able to be purchased, thus yielding more possible return, if the return ever drops below the interest rate owed to the broker, then the investor will lose money.
If after a period of time, the interest rate can no longer be paid, then the broker will liquidate the assets the investor put up as collateral.
How to Start Buying on Margin
In order to begin buying on margin, an investor needs to set up a margin account.
An ordinary brokerage account will not do, due to the fact that a portion of the money in the account does not belong to the account holder.
Margin accounts are set-up through a brokerage firm and typically require that a minimum of $2,000 be placed in the account.
Buying on Margin Example
Once a margin account has been opened, the investor may begin to purchase stock.
With most margin accounts, there is an initial margin.
Which sets the requirement for how much of the investor’s own money needs to be put into the account before any stock can be purchased.
For instance, if the initial margin is 50% and the investor wants to purchase $10,000 worth of securities then the investor needs $5,000 of their own money.
If the investor were to only invest in $5,000 worth however, therefore not exceeding the amount of money personally owned, then no margin has been used to buy.
As a result, no official loan has been made and therefore no interest rate is owed and nor are any assets collateralized.