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What Is Buying Stock On Margin?

What Is Buying Stock On Margin?

Normally when purchasing a stock the total cost of the transaction is due upon placement of the trade. It is similar to purchasing groceries at the store or gas at a convenience station in that you pay the purchase price in full at the time of sale. However, stock purchases have the option of being purchased on margin which means you can purchase more stock than you have funds immediately available. In a margin situation the financial firm is lending the investor additional money to buy more stock than they normally would otherwise. A margin loan is fundamentally different than most loans in how it is managed and the financial obligations of the investor.

What makes a margin stock purchase different than standard purchases is that the amount loaned by the broker has what is called a margin requirement. It is important to understand this concept because a stock price fluctuates either going up or down. Leveraging a stock purchase by buying it on margin means if the stock goes up you make more on your investment than you would have been able to with a standard purchase. If the stock goes down however, the investor is responsible for making up the loss on the additional stock that was purchased on margin.

Due to the fact that buying stocks on margin can be a highly risky investment if the stock price decreases, all purchases must be made in margin accounts. These are specific accounts approved by the broker and based on an investors overall knowledge and financial resources. Just like any financial institution extending credit, they will want to make sure the borrower is financially solvent enough to handle significant losses. Much like trading options, the broker is required to disclose all risks associated with margin trading. There is also often minimum requirements to open a margin account.

Other than the risk associated with a margin account, stock purchases are fundamentally the same only you're allowed to purchase more than you have cash on hand. As with any loan, the amount borrowed to purchase a stock on margin has an associated interest rate. Due to the interest rate charged, most stock purchases made on margin are for short-term investing of a few weeks or months. It wouldn't make sense to use a buy-and-hold strategy and purchase stocks on margin for years as the additional interest expense would eat away at profits.

With a margin account it's possible to purchase 1,000 shares of a $10 stock with only $5,000 on hand. If the stock increases then you make twice as much is you would have normally if you only purchased 500 shares. If the stock decreases significantly then there may be a margin call which will require the investor to deposit additional funds into the account. The New York Stock Exchange has a minimum maintenance requirement of 25% on margin accounts but individual brokers may require a higher minimum. The inherent risk with buying stocks on margin is that the value of the stock will decrease significantly requiring the investor to deposit thousands of dollars in additional funds to meet the minimum maintenance amount. If the investor does not have the required funds the broker can sell the underlying stock and then seek a civil judgment if necessary to collect on the outstanding loan amount plus any additional fees, penalties or interest.

Buying stock on margin is a good strategy for short-term investors with extensive investment knowledge and experience. It is a strategy often employed by day traders to leverage investment funds and seek a higher net return. It is recommended that an investor has significant financial resources available prior to trading on margin in case the unexpected happens and the stock decreases requiring a margin call. Sophisticated investors use margin accounts not only for buying stock but also for trading in commodities, shorting a stock and investing in foreign exchanges. If used with caution, margin trading can make an investor more money than buying a stock outright.

Image by: Peter Sunna