What Does it Mean to Buy Stocks on Margin?
Buying stock on margin allows the investor to increase the amount of stock she owns by borrowing money from the broker using stock held at the brokerage for collateral. Using leverage to buy additional stock comes at a cost, and stock cannot be leveraged on a dollar-for-dollar basis. The risks of leveraging are substantial as well.
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How to Apply for a Margin Account
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To buy stock on margin you must have first opened a brokerage account. You must fund the account and wait for the account to be approved after the broker ascertains you meet all requirements. Once the account has been approved, you will need to fill out a margin agreement. Margin agreements are also necessary if you are going to trade options as well because technically a borrowing is required.
What are the Obligations of a Margin Account Holder
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The margin agreement gives the broker the right to lend to you and to redeem your assets if you do not meet additional required calls for capital. Margin accounts must be kept at required capital levels or, according to Federal Reserve Board rules, be liquidated within 3 days of the violation. Margin accounts allow you to borrow up to 50% of the value of the account for stocks, 80% of the value of investment grade bonds. Options are not eligible for leveraging. The brokerage firm may have additional requirements.
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The Cost of Margin Borrowings
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Brokerage firms charge a fee for the lending. The cost declines as the amount of the borrowing increases. Cost of borrowing is usually based on the prime rate plus several points. Sometimes it is cheaper to borrow from a bank and secure lending rather than using your broker's facilities. It is important that whatever borrowing the investor uses that the investor has the ability to pay back the loan if the market moves against the position.
Initial and Maintenance Margin
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Margin lending is composed of two parts. The initial margin is the amount the borrower must collateralize at the time of the borrowing. If the trading position then moves in the customer's favor the investor will not need to raise any additional capital. In fact, the trader could borrow more funds and use them for other purposes. However, if the trade goes into a loss position the investor will have to deposit more cash or stock or liquidate the position. This is called maintenance margin.
Limitations on Margin Use
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At times it is possible to receive enough bond and stock dividends to cover the interest charges. Penny stocks and stocks trading on major exchanges below $5 cannot be used for margin. Investors using margin should examine whether the psychological fact of being in debt on a stock position will affect their trading style. Margin debt is a powerful tool when used for brief trading plays. As a long-term investment style, it is a high-cost, high-risk situation.
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