Buying on Margin

Increase your margin by leveraging that margin

What does buying on margin mean?

Margin trading or buying on margin means offering collateral, often with your broker, to borrow funds to purchase securities. In stocks, this can also mean purchasing on margin through a portion of open positions in your portfolio that are generating gains.

This practice allows investors to control more funds than the cash that they own. An investor will, however, need to open a margin account with a broker first, in order to conduct margin trading.

In practice

The broker will assess an investor regarding his creditworthiness and risk. After assessment, the broker will set an “initial margin” requirement and a “maintenance margin.”

The initial margin will differ depending on instrument traded. If the broker sets an initial margin of 50% for one lot position @$100 AAPL, then the investor needs 50% times $100 per share times 100 shares per lot, or a margin of $5000 on his portfolio to purchase one lot position. Alternatively, he may place $5000 worth of collateral to guarantee this margin.

The maintenance margin is like a debt covenant for leveraged firms. It is the total margin needed to maintain opened positions. If a broker sets this margin to 30%, for example, on an account valued at $10,000, then the investor must maintain at least $3,000 in margins. If his gains fall below this margin, the broker will initiate a ‘margin call’, which requires the investor to deposit more funds to comply with the margin requirement. If his gains repeatedly dip below the maintenance margin, the broker might force liquidation of the investors open positions to comply with the requirement.

Benefits and risks

The main benefit of margin trading is maximizing potential profit when investors are confident that prices will increase in the future. In essence, the practice allows investors to increase their portfolio beyond the size of their real available funds.

The biggest risk, however, is the possibility of ruin through forced liquidation. The higher margin used, the higher the returns, but also the higher the risks.