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When you don't have enough available money to purchase the securities you desire, you can borrow money from a broker-dealer: this is called buying on margin. In this tutorial, we will cover the basics of using margins. We will discuss the following:
WHY BUY ON MARGIN?
Let's begin with an example. Suppose you believe that a particular stock will rise in price. It is currently trading at $10 per share and you believe it will soon hit $20. Currently you only have $3,000 in cash to buy 300 shares. You can borrow $3,000 on margin from your broker and invest the total $6,000 for 600 shares. If the stock hits $20, your holdings will be worth $12,000 and you can then sell them for that price. You pay back the $3,000 you borrowed, leaving you with your original investment of $3,000 and a tidy gain of $6,000 (before commissions and interest). The chance to magnify your earnings is what buying on margin is all about.
However, if the stock declined to $7 a share and you sell, you receive only $4,200. From this amount, you must repay the $3,000 you borrowed. Thus, leaving you with $1,200 of your original $3,000, before commissions and interest.
Buying on margin is a strategy for the short term, since holding on to borrowed money too long could result in a loss. You are responsible to meet all margin calls promptly and you are responsible to repay all funds borrowed on margin, even if this amount exceeds the value of your account.
As with all investing, there is risk in buying on margin. One of the biggest reasons many people lost lots of money in the stock market crash of 1929 was that they borrowed too much and could not pay back their loans. The government stepped in soon after to create limits.
RULES FOR BUYING ON
MARGIN
After the market crash of 1929, the government enacted laws to help prevent the practices that led to the crash. Federal Reserve Board Regulation T sets margin requirements. Regulation T requires that the customer put up a percentage of the total investment amount. The Federal Reserve Board sets this percentage but changes it periodically to keep speculation under control. Currently the margin requirement is 50%. However, some brokerages may require more than 50 percent. You may use fully marginable or partially marginable securities you already own as collateral for the margin. Conversely, you may borrow up to 50 percent of the value of your marginable portfolio. The broker-dealer holds the marginable shares as collateral. You pay the broker interest and commissions on the transactions.
To buy on margin, you must have a margin account. You can put up your collateral in cash or securities. You are allowed to add money or securities to your account.
The initial margin is the smallest amount that the investor must pledge at purchase. The bare minimum that must stay in the account is the maintenance margin. When the balance falls below this amount, if the margined securities drop in value, the investor will get a margin call, which is a demand that the account be brought back up to the maintenance margin. If the customer cannot meet the margin call, the broker may sell any and all of the customer's margined securities to meet the call. The maintenance margin on equities is usually 25%. The customer is responsible for any remaining deficit.
WHICH SECURITIES CAN BE MARGINED?
The following securities can be margined:
- Listed common and preferred stocks
- Municipal bonds
- Federal government bonds, notes and bills
- Over-the-counter securities on the NASDAQ and the National Market System
- Convertible bonds
- Corporate bonds
Always check with your brokerage firm to determine whether a security is, 1)marginable, and 2) fully marginable. Some securities are marginable only up to a certain value of the security while still other securities are non-marginable all together.
With an IPO, you must wait at least 30 days after a security has been traded in the secondary market before the security may become marginable.
Mutual funds and certain options may not be bought on margin or used as collateral in a margin account.
SHORT SELLING
Margin accounts are not just used for buying-- you can also use them to sell securities. This is called short selling, or shorting. This practice involves borrowing securities you believe will decline in value and then selling them. You are selling securities you do not own. Looked at another way, short selling is about selling high and then buying low, just the opposite of regular trading. Once you have sold your securities, you hope that the price falls, in which case you buy them back for a lower price. If the price rises, you may be forced to buy the shares back at the higher price and lose money on the transaction. Remember--you have to buy them back because you must return them to the brokerage firm. If the price rises, you may be forced to buy the shares back at the higher price and lose money on the transaction. Here is an example:
You really believe that Chocolate Beer, Inc. (CBI), which is currently $10 per share, is going to fall very far and very fast. You borrow 100 shares of CBI from your broker and sell them for $1,000. Soon afterward, the stock drops to $4 a share, at which price you buy the 100 shares back for $400. You come out $600 ahead (before commission and interest).
If Chocolate Beer, Inc. becomes a hit and its price rises, you will take a loss. Let us say it rises to $15 by the time you must repay the shares. It will cost you $1,500 to buy those 100 shares back. Thus, you must pay $1,500 to replace the shares you sold for $1,000. You must also pay commission and interest costs as well.
Dividends or interest earned on the shorted security belong to the person from whom you borrowed it. The broker can also demand that you return the shares at any time regardless of whether the price is up or down.
Buying on margin is usually simple, but it is risky. If you buy a security with it, and it nose-dives in value, you cannot rescue it with more margin buying. Margining magnifies earnings, and it can magnify losses as well.
This concludes the tutorial on Buying on Margin.
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