Lesson 7 of 10
Buying on margin refers to taking a loan from the broker to purchase stocks. The loan from the broker is known as broker call loan. This allows you to buy more shares than you would have normally using just your own funds, that is, an investor is able to leverage his position by investing his own funds as well as borrowed funds.
The investor has to pay a commission or fees and interest to the broker for the loan. The stock thus purchased remains with the broker as the collateral.
The phenomenon of using borrowed funds to take a higher risk position is known as leverage. For example, if an investor has $1000 and he borrows another $1,000 from the broker and takes a stock position for $2000, then the investor is said to be leveraged 2 times (2x).
A few regulatory authorities have a limit on the amount of leverage that can be allowed for margin trading. In the USA, the Federal Reserve sets this leverage limit at 2x, which means that means an investor cannot borrow more than 50% of funds for any trade.
Buying on margin is usually for short-term investments. Also, not all stocks are available for margin trading. Federal Reserve lists the stocks that are available for margin trading. Generally penny stocks and IPOs are not available for margin trading because of high risk of daily fluctuations.
Once you have purchased a stock on margin, the value of your position will rise or fall based on the price movement, which will affect your equity and funding position.
For example, assume that you have purchased a stock for $20,000 with $10,000 as own funds (equity) and the remaining 10,000 as borrowed funds. Here your equity is 50%, which is the initial margin.
Now if the stock position falls to $15,000, this loss will be attributed to the equity. So, remaining equity is $5,000 and the margin has reduced to 33.33% ($5,000/$15,000). The collateral value is sufficient to cover the call loan of $10,000.
However, if the equity reduces further, the broker may want you to deposit additional funds to increase the margin to a certain minimum level. This request is known as margin call. The threshold at which the broker triggers a margin call is knows a maintenance margin, and the minimum margin that the broker wants you to maintain is known as initial margin.
For example, the broker may trigger the margin call when the equity has reduced to less than 10% (maintenance margin), and will request you to top up the account so that the initial margin is above 25%.
If you don’t fulfill the margin call, the broker may liquidate the stock position in order to safeguard his position.