Securities: Margin Trading

Securities and Margin Trading

Buying on Margin

When purchasing securities, investors have easy access to a source of debt financing called broker’s call loans. The act of taking advantage of broker’s call loans is called buying on margin. Purchasing stocks on margin means the investor borrows part of the purchase price of the stock from a broker. The margin in the account is the portion of the purchase price contributed by the investor; the remainder is borrowed from the broker. The brokers, in turn, borrow money from banks at the call money rate to finance these purchases; they then charge their clients that rate, plus a service charge for the loan. All securities purchased on margin must be maintained with the brokerage firm in street name, for the securities are collateral for the loan.

Margin Requirements and Maintenance

The Board of Governors of the Federal Reserve System limits the extent to which stock purchases can be financed using margin loans. The current initial margin requirement is 50%, meaning that at least 50% of the purchase price must be paid for in cash, with the rest borrowed.

Margin Calls and Maintenance Level

If the stock value falls below a certain point, a margin call may be issued by the broker. A margin call requires the investor to add new cash or securities to the margin account. If the investor does not act, the broker may sell securities from the account to pay off enough of the loan to restore the percentage margin to an acceptable level.

Risks and Benefits of Buying on Margin

Investors buy securities on margin when they wish to invest an amount greater than their own money allows. By doing so, they can achieve greater upside potential but also expose themselves to greater downside risk.

Upside Potential

When an investor borrows money to invest in securities, their rate of return can be magnified. For example, if the investor expects a stock to go up in price, they can leverage their investment and potentially achieve a higher rate of return.

Downside Risk

However, buying on margin magnifies the downside risk as well. If the stock price goes down, the losses are also amplified. The investor may end up owing more money than the value of their investment.

Example: Investing on Margin

Let's consider an example to understand the potential returns and risks of investing on margin.

Scenario

An investor is bullish on FinCorp stock, which is selling for $100 per share. The investor has $10,000 to invest and expects FinCorp to go up in price by 30% during the next year. Ignoring dividends, the expected rate of return would be 30% if the investor invested $10,000 to buy 100 shares.

Investing on Margin

Now, let's assume the investor borrows another $10,000 from the broker and invests it in FinCorp as well. The total investment in FinCorp would be $20,000 (for 200 shares). Assuming an interest rate on the margin loan of 9% per year, we can calculate the investor's rate of return if FinCorp stock goes up 30% by year’s end.

Calculation of Rate of Return

The 200 shares will be worth $26,000. After paying off $10,900 of principal and interest on the margin loan, the investor is left with $15,100 (i.e., $26,000 - $10,900). The rate of return in this case will be:

(Investor's Final Amount - Investor's Initial Investment) / Investor's Initial Investment = Rate of Return

($15,100 - $10,000) / $10,000 = 51%

The investor has parlayed a 30% rise in the stock’s price into a 51% rate of return on the $10,000 investment.

Downside Risk Example

Let's consider the scenario where the price of FinCorp stock goes down by 30% to $70 per share. In that case, the 200 shares will be worth $14,000, and after paying off the $10,900 of principal and interest on the loan, the investor is left with $3,100. The result is a disastrous return of:

(Investor's Final Amount - Investor's Initial Investment) / Investor's Initial Investment = Rate of Return

($3,100 - $10,000) / $10,000 = -69%

If there is no change in FinCorp’s stock price, the investor loses 9%, which is the cost of the loan.

This article takes inspiration from a lesson found in FIN 4504 at the University of Florida.