Requirements for Buying Stocks on Margin

Profit-seeking investors are always looking for ways to improve the return on their investments. Buying stocks on margin is one method. The essence of margin trading is simple: You put up part of the money to buy a stock or other security and borrow the rest. That enables you to buy more stock, increasing your potential profit. It also increases risk. If a stock goes down in price, you will lose money faster, just as you make money faster if the stock appreciates. The requirements for buying stock on margin are more stringent than for regular stock purchases because of the use of borrowed money.

Account

To buy stocks on margin you must have a brokerage account with margin privileges. In reality, you are opening a credit account that allows you to borrow money. The broker will check your credit rating and ask for information about your income and assets. Federal law requires the broker to fully inform you about all of the risks associated with margin trading. You will also need to sign a hypothecation agreement. This is a statement that all of the securities and cash in your account are collateral for any funds on loan to you. The minimum deposits for opening margin accounts are higher than for regular "cash" accounts. For instance, in 2009, a cash account minimum deposit is usually around $1,000, but a margin account from the same broker might require $2,500.

Margin Requirement

The Federal Reserve Board (FRB) sets the minimum margin requirements for buying stocks on margin. Most of the time, you must put up 50 percent of the price of the stock. However, the FRB occasionally raises the margin requirement, depending on economic conditions. The brokerage firm charges interest on the borrowed money, though at low rates. Margin trading is not generally available for "penny stocks" priced at less than $5 per share.

Maintenance Requirement

If stock bought on margin drops too much in price, the broker issues a margin call. When this happens is decided based on whether you continue to meet the "minimum maintenance requirement," which the New York Stock Exchange sets at 25 percent of the value of the stock. If your equity falls below that level, you have to add money to your margin account or the broker must sell the stock to recover the money you borrowed. For example, if you buy a stock at $30 per share, putting up $15 per share, and the stock falls to $20 per share, all of the loss comes out of your end. You are left with equity of $5 out of the new price of $20 per share, or 25 percent. If the stock drops any further, you get a margin call.

Day Trading

Day traders use margin trading as a primary trading strategy, buying and selling shares in rapid-fire succession as they try to make profits off the daily fluctuations in stock prices. The rapid turnover means old transactions are still open as new ones are being started. Due to the risks that go with this form of stock trading, brokers require much larger minimum balances for day traders. If the regular minimum for a margin account is $2,500, day traders may have to keep 10 times that ($25,000) in their accounts.

Considerations

The margin requirements mentioned above are those mandated by the FRB and major stock exchanges. Brokers may impose stricter standards if they choose. This does happen on occasion when the market is unusually volatile. Also, the margin requirements for buying stocks are not the same as for other types of securities. Commodity and currency trading has far lower margins and most trading is done on margin in those markets. You can also buy bonds and options on margin as well. Each market has its own set of rules.