Buying on Margin - Explained
What is Buying on Margin?
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Table of ContentsWhat is Buying On Margin?How Does Buying On Margin Work?Academic Research on Buy on Margin
What is Buying On Margin?
Buying on margin involves purchasing an asset using leverage and getting a broker or bank to fund the balance. It refers to the down payment that an investor makes to a broker for the asset purchased i.e. 90% financed and 10% down payment. Two factors usually determine the buying power: the amount of collateral available in the brokerage account and the investors margin capacity. Margins are also used by short sellers to borrow and sell shares in the stock market. In the United States, margins are controlled by the Federal Reserve Board. Since 2016, investors are expected to fund at least 50% purchase price of the security using cash.
How Does Buying On Margin Work?
When one purchases securities on margin, the money is paid back with an interest which always varies depending on the loan amount and the brokerage firm. Like loans, there is no set repayment period; brokers can repay the principal at their own convenience. Additionally, in the case that the margin is used to purchase taxable investments of certain limitations, the margin interest is subject to tax deductible. Before an investor begins buying on margin, the broker is expected to set both initial and maintenance margin in the account. This amount is always determined by the creditworthiness of the broker among other factors. Maintenance market is the minimum cash that must be in an account before an investor deposits more money. For example, in a case that an investor makes a $10,000 deposit that is subject to a 50% maintenance margin, then the investor may receive a margin call in case the equity drops below the 50% ($5,000). In such a case, the broker makes a call to the investor to bring the balance up to the maintenance margin level. The investor can then make a deposit of additional cash to the brokerage account or sell the securities used to purchase the money borrowed. Other uses of margins include future contracts although securities such as options contacts do not permit buying on margin; investors must make purchase with 100% cash. It is important to note that buying on margin may attract a lot of risk. When using someone elses money to purchase securities, gains may be amplified when the securities value increases; however, the losses may also magnify in case the value declines.
Example of Buying On Margin Works
For seeing the working or functioning of buying on margin, and making it look simpler, we shall avoid the monthly interest expenses. The interest rates dont create much of an impact on returns and losses as marginal principal does. For instance, an investor invests in 100 shares of XYZ company for $50 per share. He manages to pay 50% of the purchase price ($2,500) using his own funds, and the remaining 50% with buying on margin. When the price of the share rises to $100, he can sell shares for a whopping amount of $10,000. From this amount, he can reimburse the broker with $2,500, which was the amount he borrowed in the initial stage. Considering the calculations, he managed earning $7,500 by investing one-third of the amount, $2,500. If he had purchased the similar number of shares by financing himself, then he would have earned $5,000 on his investment of $2,500. Considering the downside, if the price of the share reduces from $50 to $25, the investor will incur a loss of $2,500. As the amount that he earned was equal to the amount he needed to pay to his broker, he wont be earning anything on his investment. If he wont have bought it on margin, he would have managed saving 50% of his investment, which is $1,250.
How to Buy on Margin
The broker or intermediary creates initial margin and maintenance margin by considering the credit history of the borrower, how quickly he/she can pay back the amount and the interest. These two types of margins must be there in the account prior to the investor uses buy on margin approach. Maintenance margin, as the name suggests, is the minimum amount that the investor must maintain before the intermediary or broker asks the investor to add more money. For example, an individual invests in $10,000 with the maintenance margin being 50% ($5,000). When the equity starts falling below $5,000, the broker gives a margin call to the investor reminding him/her to maintain his balance at least to the maintenance margin. The investor can bring the balance back to said margin level either by adding more cash, or by selling off securities that he bought from the money borrowed. In case, he is unable to do so, the broker can start selling off his securities so as to bring maintenance margin to a certain amount.
Academic Research on Buy on Margin
- A re-examination of the Modigliani-Miller theorem, Stiglitz, J. E. (1969). The American Economic Review, 59(5), 784-793. This paper re-examines the Modigliani-Miller theorem to prove that given a general equilibrium state preference model, this theorem holds under more general conditions than the ones assumed in the original study.
- Buying on margin and short selling in an artificial double auction market, Zhou, X., & Li, H. (2017). This paper discusses the influence of leverage trading on financial markets using an agent-based artificial market model. Using an artificial market, the model reveals that while a one-sided market leverage trading increases volatility and liquidity and decreases price-discovery efficiency, a two-sided market increases liquidity only by a small margin, decreases volatility and improves price-discovery efficiency.
- Margin requirements, margin loans, and margin rates: Practice and principles, Fortune, P. (2000). New England Economic Review, 19-44. This paper presents an analysis of the volume of margin loans as well as a description of the history and practice of margin requirements and the accounting framework.
- Futures contracting and dividend uncertainty in experimental asset markets, Porter, D. P., & Smith, V. L. (1995). Journal of Business, 509-541. This journal explores the concept of experimental asset market, asserting that prices in such a market always bubble but crash to dividend value at the end of the useful life of an asset. According to the authors, this likely occurrence is as a result of: inability of participants to form reliable future price expectations; and dividend risk aversion.
- Short-selling, margin-trading, and price efficiency: Evidence from the Chinese market, Chang, E. C., Luo, Y., & Ren, J. (2014). Journal of Banking & Finance, 48, 411-424. This article discusses the effects of lifting a ban on stocks short-selling and margin-trading. Based on the authors observation, when the ban is lifted, stocks experience negative returns; price efficiency increases while stock return volatility decreases.
- Stock market margin requirements, Moore, T. G. (1966). Journal of Political Economy, 74(2), 158-167. This study presents data on the effectiveness of margin requirements to show that the objectives behind the legislation which established margin requirements have not been realized.
- The effects of short-selling and margin trading: a simulation analysis, Setzu, A., & Marchesi, M. (2006, June). In 1st International Conference on Economic Sciences with Heterogeneous Interacting Agents (WEHIA 2006) (pp. 15-17). This paper uses the multiagent simulation model to examine the effects short-selling and trading margin requirements on a stock market. Experimenting both at the open and closed markets, the model revealed that there are random cash inflow or outflow 10 simulation days apart.
- Stock market margin requirements and volatility: Implications for regulation of stock index futures, Salinger, M. A. (1989). In Regulatory reform of stock and futures markets (pp. 23-40). Springer, Dordrecht. This article discusses the existing correlation between stock market margin purchase and volatility. It also discusses the effects of futures markets margin requirements regulation. Since 1934 when the Federal Reserve set margin requirements to date, the article reveals that there has never been a correlation between margin requirements and margin debts.
- Margin trading bans in experimental asset markets, Fllbrunn, S., & Neugebauer, T. (2012). (No. 2012, 058). Jena Economic Research Papers. This study aims to assess the impact of margin trading on the price process and liquidity in financial asset markets. In particular, the study conducts a comparative static analysis involving a ban of margin purchases in an experimental asset market and control market situation. Results of the study reveal that bank on margin purchases promote pricing efficiency by narrowing price deviations from fundamental value.
- Forward and futures prices: Evidence from the foreign exchange markets, Cornell, B., & Reinganum, M. R. (1981). The Journal of Finance, 36(5), 1035-1045. This Finance Journal discusses the substantial differences between futures price and implied forward price in relation to taxes, settling up procedures in the future markets, and transaction costs.
- Margin requirements and equilibrium asset prices, Coen-Pirani, D. (2005). Journal of Monetary Economics, 52(2), 449-475. This paper evaluates the effect of margin requirements on asset prices and trading volume in a general equilibrium asset pricing model where EpsteinZin investors differ in their degree of risk aversion. The author illustrates how binding margin requirements do not affect stock prices.