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Investing by Buying Stocks on a Margin

Updated on February 21, 2013

Borrowing Money To Purchase Stocks

When we talk about buying stocks on a margin we are talking about borrowing money to purchase the stock and securing the load with the stock.

In effect what a person is doing here is borrowing money from their broker or some other lender, using the money to buy stock and then pledging or promising the lender that the stock will be sold to pay the loan in the event the stock falls in price. When a person purchases stock on a margin, the lender only loans them part of the price and the person purchasing the stock has to come up with the difference.

The difference between the amount borrowed and the current value of the stock is the purchaser's equity, or amount of the stock value that is theirs versus the portion of the value represented by the loan in the investment.

The lender, of course, will only loan a certain percentage of the purchase price. If the maximum amount the lender will lend is 60% of the investment then the purchaser will have to come up with the remaining 40% of the price.

Thus, if a stock is selling for $100 per share and you wish to purchase 100 shares the total cost (ignoring broker commissions and other fees) will be $10,000 (i.e., 100 shares times $100 per share = $10,000). The lender will lend you up to 60% or $6,000 and you have to come up with $4,000.

The lender will require that your equity always be at least 40% of the original value of the purchase. So long as your equity is at least 40% of the original purchase price it means that the lender can still recover the entire amount of their loan to you by selling the stock.

If you borrowed the full 60% of the price that the lender was willing to lend then any increase in the price would increase your equity since the stock is now worth more. However, any drop in the price of the stock below the original price would trigger a margin call.

Margin Calls

A margin call is when the lender demands that you either pay down the loan to the point where it is no more that 60% of the new price or the lender will exercise its right to sell the stock and get its money back rather than risking a further price drop to where the total value of the stock is less than the amount it has loaned.

For instance, using the example above, let's assume that the stock was selling at $100 per share and you wished to purchase 100 shares but only had $4,000 of the $10,000 needed to make that purchase.

So you borrowed the maximum allowed, $6,000 which is the 60% of the purchase price that the lender is willing to lend. Then, instead of going up as you had anticipated the price of the stock dropped to $95 per share reducing the value of your investment to $9,500. The $6,000 loan now represents 63.2% of the value of the investment while your equity (the portion that you own outright and not covered by the loan) in the investment has dropped to 36.8%.

You either have to pay the lender $300 to reduce the loan balance to $5,700 which is 60% of the new value of the investment or have the lender sell part of your stock to get the money they loaned back.

Had you invested $5,000, or half the purchase price, then you would have only had to borrow 50% of the price which would have given you a cushion in the event of a drop in the price of the stock in that, with a 50% equity position the stock would have to drop by more than 10% before your equity in the investment fell below 40% and you faced a margin call.

Advantages of Purchasing Stocks on a Margin

So, given the risks of a margin call, why would someone want to purchase stock on a margin? The reason is leverage.

If you study the company whose stock in the above example is currently selling at $100 per share and conclude that this stock could easily increase to $125 within the next few months then a $10,000 investment in that stock would allow you to purchase 100 shares now and sell them in a few months for $12,500 (100 shares times $125 per share) giving you a $2,500 profit.

However, you only have $5,000 to invest at the moment which would limit your purchase to 50 shares and limit your anticipated profit to $1,250 (this example, of course ignores commissions and other transaction costs). By borrowing the additional $5,000 and doubling your investment you can double your profit.

There is, of course the risk that the stock price may drop before it rises and, if it drops below the margin requirement you may be forced to sell it and lose your money while, if you had not borrowed, you could have held on until it did go up as anticipated.

Used wisely and cautiously, buying on a margin can be profitable. However, a sudden drop in the price of a stock or sudden drop in the market as a whole which occurred in the Fall of 2008, can result in many investors having their stocks sold at a low price to meet margin calls. Of course this sudden and large scale selling to meet margin calls serves to drive falling stock prices down even faster.

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    • NaturalGasStocks profile image

      NaturalGasStocks 5 years ago from New York, NY

      Excellent hub, great information for those just getting into the game!

    • profile image

      theking2020 5 years ago

      Buying on margin yields incredible results if you can leverage your investments properly, there can always be a stop lost place as well as a price you wish to sell it at to be able to make profits.

    • mpoche4 profile image

      Michal 5 years ago from Baton Rouge, LA

      Chuck- this is a great hub that shows both the risk and potential advantages to buying stocks on a margin. I do not follow the stock market closely enough to venture out and take the challenge, but if you are market savvy, why not go for it. As with any investment, it is best to only invest what you are willing to lose as most times, profit is not a sure bet. Because you are at risk of the bank calling back a loan, this does make this different that simply risking your own funds on an investment though. Thanks for this hub- it was a well structured!

    • Ramsa1 profile image

      Ramsa1 5 years ago from A citizen of the World

      I have never bought stocks on margin. I think it's too risky and dangerous for most people. I would also not use my home as collateral for a loan to buy stocks. Believe it or not, my bank once offered this to me.

    • Aceblogs profile image

      Aceblogs 5 years ago from India

      Well i would really say it is very well explained. I myself is a big time investor in indian stock markets and normally i prefer to buy delivery thatn going for margin buying as the intraday margin settles out at the end of the day and thus one can even end up in losses

    • profile image

      implantingideas 5 years ago

      Hi,

      This is well explained. I have introduced a swing trading system that is back tested on Dow Jones past 70 years and it has been perfect. It is an ideal for traders. I am willing to share my system. Please let me know your interest.

    • profile image

      SUBODH 5 years ago

      WELL EXPLAINED.

    • profile image

      David Letingon 5 years ago

      Margin is a tricky subject. Most people think it's a terrible thing. I think it's a necessity for serious day traders. Finding the broker that has the best rates is key to trading on margin. www.buysellstockonline.com has a good list of brokers to choose from.

    • Paul Kohler profile image

      Paul Kohler 6 years ago from Cleveland, Ohio

      Thanks for the advice, I want to start investing so I appreciate you explaining it so well

    • profile image

      oporajita 6 years ago

      Well explained hub. Your experience and knowledge will surely help others .

      http://www.ultimate-traders.com

    • positivevibestech profile image

      positivevibestech 6 years ago

      Great info i just came across this but it is definitely telling of how many go caught in the last selloff

    • TradingStocks profile image

      TradingStocks 6 years ago

      Thankyou for these tips on buying on margin. The good thing to remember is that you can use all available margin or less if you wish, to 'magnify' your trading results more or less.

    • profile image

      Jonha @ Happiness 6 years ago

      I am new to stock market investing and I think it is very essential that every aspiring investors should equip themselves with ideas and tips like these. Thanks for informing me about the possibility of buying stocks on margin.

    • profile image

      Mike 6 years ago

      Thanks so much for the explanation! I've been trying to decide on a discount brokerage over the past little while and all of them seem to ask whether you'd like to invest using a margin account or a cash account. You make a good point about leverage in favor of a margin account, but I always get freaked out when I read about how The Great Depression was partially caused by people overusing margin accounts in the 1930s.

    • barryrutherford profile image

      Barry Rutherford 6 years ago from Queensland Australia

      Ive been hurt with margins calls I will not do that again... too painful...

    • mel22 profile image

      mel22 7 years ago from ,

      simple explanation... thanks 4 the info!

    • profile image

      Nicks 7 years ago

      A good Hub - certainly margin buying is not for the faint hearted. But then the stock market is not far off straight gambling and you should never expose yourself if you cannot afford to lose your investment - without a shrug of the shoulders.

    • OpinionDuck profile image

      OpinionDuck 7 years ago

      1929 no margin limits, boom

    • Susana_Panca profile image

      Susana_Panca 7 years ago from Indonesia

      Most informative hubs. Explain in plain simple words.

      I knew to the market stock. Hope I can gain more info here.

    • johnr54 profile image

      Joanie Ruppel 7 years ago from Texas

      Some tax sheltered accounts like most IRAs don't allow margin investing, but you can accomplish much the same thing with the leveraged ETFs that are becoming available for many sectors (and have been available for the overall market for years.)

    • Springboard profile image

      Springboard 7 years ago from Wisconsin

      I don't have a formula for it, I treat each investment individually based on a number of criteria and so exit strategies are included in that, but I generally keep things so that even if margin were ever called—even across the board—it's not curtains. Now, I know some would say "well, that defeats the whole idea of using margin." But to that I say, you NEVER invest or trade dollars you do not have and if you ARE using margin, it's best to ensure that the ROI you anticipate will outweigh the cost of the margin fee, which makes the margin a bargain and a benefit.

    • Chuck profile image
      Author

      Chuck Nugent 7 years ago from Tucson, Arizona

      scheng1 - thanks for your comment.

      You are correct in that buying on a margin can be risky which is why I devoted a section to discussing Margin Calls.

      However, margin buying can be a good tool for an investor. We just have to assume that since only adults can legally enter into contracts to borrow money that know what they are doing before they enter into an arrangement that involves margin purchases.

      Adults do have the right to make their own decisions and, included in this right, is the right to make bad or even stupid decisions.

      Thanks again

      Chuck

    • profile image

      scheng1 7 years ago

      It's very risky to buy on margin, either win big or lose big, especially when trading without covering position.

    • profile image

      prevodi 7 years ago

      Great info. My advice regarding leverage is: the greater the leverage, the less margin for error. So if you are not sure about expected return for some investment, the best leverage is zero.

    • Legacy Wellness profile image

      Legacy Wellness 7 years ago from Katy, Texas

      Great information. I don't have the risk tolerance to buy on margin or for that matter, GO NAKED. WOW, that statement will make some people wonder. lol

    • jayb23 profile image

      jayb23 7 years ago from India

      Awesome hub Chuck. You have explained the terms on margin money really well. Keep up the good work.

    • neysajasper profile image

      neysajasper 7 years ago

      Nice hub Chick, it is really informative i enjoyed it very much. Keep it up!!!

    • lvbags profile image

      lvbags 7 years ago

      Hi Chuck,

      Very good and simply described hub. It will even help the newbies in the stock markets.

      I think you will like the brad watches in http://www.ebuy4cheaps.com when you see it. As the reason that all is brand and cheap..

      find my happiness..

    • JYOTI KOTHARI profile image

      Jyoti Kothari 7 years ago from Jaipur

      Hi Chuck,

      Very good and simply described hub. It will even help the newbies in the stock markets.

      I liked your caution words. It is dangerous to buy stocks on margin especially in a volatile market.

      One has to lose his principal amount along with interest, commission and other charges out of greed.

      Some allow up to 75% in some countries like India.

      I have also written some hubs about stock market and welcome you for your suggestions.

      Thanks and thumbs up!

      Jyoti Kothari

    • Darren2010 profile image

      Darren2010 7 years ago

      Hi Chuck, Great Hub on leveraging. I find that margin has received a bad rap and has been labeled 'evil' or 'wrong'. I've always thought it's neither good or bad, it is just a magnifier. If you make good decisions in the market than on average you will get more benefit. If you make bad choices then you will crash and burn that much faster.

    • Marc Abrams profile image

      Marc Abrams 7 years ago

      Great Hub! It is important that people understand both sides of leverage. Your returns will be significantly higher when the investment is properly leverages when things go up. However, your losses will also be significantly greater when they go down. Unfortunately many people with high loan to value ratios in real estate are learning that difficult lesson now.

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