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what was buying on margin

Lend me an ear, please! I've heard a lot about buying on margin, but I'm still unclear how it works. How about a clear explanation?

Sure. When you buy on margin, you're simply borrowing money from your broker to buy stock. Your collateral is the marginable securities in your account. Currently, you put up 50% of the purchase price of the stock you wish to buy and borrow the other half from your broker. It's important to remember, though, that not all stocks are marginable (that is, able to be purchases on margin). Here's the scoop on that!

Very well. Now tell me if all stocks can be bought on margin? Are there restrictions I should know about?

No, and having begun to buy on margin, you must be very careful about this. Stocks under $5/share are not marginable. Initial Public Offerings (IPOs) are not marginable for a certain period after their debut. Now and then, you'll also find that other Nasdaq stocks are not marginable. Why must you be careful? While you may have enough buying power in your account to cover that purchase, you may not have enough cash to do so. Thus, having failed to realize that buying power is not relevant because you're buying a non-marginable security, you will get a Fed call from your broker. You must then send in more cash to cover the purchase and do so within three days. Be absolutely sure you know precisely what you are doing each and every time you buy on margin! You can't be too careful in this regard.

You must also remember that non-marginable securities do not contribute to your margin buying power. Buying power is discussed below.

OK, I put up half and my broker puts up half, but I'm still foggy on what this buying power is that I keep hearing about. Can I get an example explained? Using numbers? Let's say I have $10,000 in my account, how much buying power do I have? What happens if I then buy $8,000 of Polonius's Problem (LOAN)?

Sure, it's really quite simple. That $10,000 in your margin account provides you with $20,000 in buying power. That's because (as noted above) you must put up 50% of the purchase price of the stock you wish to buy.

Now, when you shell out $8,000 to buy your LOAN, you're left with $12,000 in buying power (ignoring commissions, for the sake of simplicity), $2,000 in cash and $10,000 that you can borrow from the broker. You don't actually borrow the money until you run out of cash but it's still there for you to use.

One aspect of buying on margin that you must remember is that the buying power of your account can change daily. This, of course, is the result of the change in the share prices of the marginable securities in your account. If, overall, the share prices of your long margin positions rise, you're OK. However, if share prices fall, you may get a margin call from your broker. That topic is next.

I just received a maintenance call from my broker. What is that?

Brokers require that the equity in your account (that's the market value of the securities minus the amount you owe the broker) remain above a certain percentage. If, due to a fall in the value of your marginable long positions (or rise in the share price of any short positions you have), the equity falls below this percentage, you hear from your broker in the form of a maintenance call.

What then? Well, your broker will want additional funds from you to bring your account equity back above the minimum level. You may simply send in more money, or close one or more positions in your account to achieve this. Incidentally, the minimum equity percent varies among brokers. I believe it ranges from 35-50%.

I see that there's a lot more to buying on margin than I thought. Would some enterprising Fool run through the advantages and dangers of buying on margin for me?

Sure. The advantages and dangers are two sides of the same coin - the increased buying power afforded you by buying on margin. Let's look at the bright side first.

Let's say you're a fine, fine stock picker. You've begun with $10,000 in marginable securities ($20,000 buying power, remember), and by great stock picks, you've parlayed it into $20,000 in marginable securities. This rise in the market value of your account has increased your

buying power! Now, you may, if you wish, use that increased buying power to buy more great stock picks. What you're doing is using the profits achieved by your great stock-picking without having to sell your existing positions. Thus, in a way, using margin enables you to access your profits without suffering the bite of capital gains. Pretty nifty, you think?

Wait, as in all things in life, there's a dark side to this story. Check out MF Banjo's thoughts on the dangers of buying on margin.

The problem is that, in a severe market decline, you could lose so much capital that you would never recover. For example, suppose you maintain investment at 50% margin (that is, you own $2 in stocks for every $1 in capital). If the market declines 25%, you would expect your portfolio to lose 50% of its value. That's painful, but you say you can live with that. But if you are invested in less liquid, volatile stocks, like many of those recommended on these boards, you could easily lose 70 or 80% of your capital in a severe market correction. If you lost 75%, you now have to have a 4-fold return just to break even. Two bad years in a row, and you are essentially wiped out, right when the market is so cheap it makes your mouth water.

Others have made what I consider to be a reasonable a case for using a small amount of margin (120-125% long), but being 200% long exposes you to too much risk, in my opinion.

Buying on margin is also psychologically dangerous. It's like a credit card. If you're not careful, you can come to think of the money as something unreal. Don't be fooled. It's not. Your broker wants every penny back and will get it. Also, don't forget that while on margin, you're paying interest for the privilege of borrowing that money. While the interest rates are not anywhere near those of a credit card, they are real and detract from your profits, or, gulp, add to your losses.

Hmm, I suppose if buying stocks on margin can be dangerous, shorting stocks that way can be lethal. That is, if you even can do so. Is it possible to short stocks on margin?

Yes, it's possible and yes, it can indeed be more dangerous than going long. In fact, you can only go short in a margin account. When shorting, you can and should set an absolute maximum loss you're willing to sustain. Unlike a long position, entered because you perceived prospects for future growth that can sustain you should the stock fall (and the growth prospects remain), if a short position gets out of hand, you may not see it return to a reasonable level. Waiting it out is rarely the right thing to do. In my experience, overpriced stocks often became overpriced due to the frantic buying practices of momentum investors. As all students of science know, momentum can be a hard thing to reverse. Sure, once the momentum crowd has moved on, the stock may fall back some. But how long will that take? How low will it subsequently fall? Most importantly, how much has it cost you in the meantime? So, when shorting stocks on margin, set those limits and stick to them!

Now let's look at the mechanics of shorting on margin. In a margin account, margin interest is paid on the amount of money the short positions are in the red. That is, if one shorted 1000 shares at $10/share and the share price rose to $12/share, interest payments would be due on $2,000. More importantly, that $2,000 comes right out of margin cash available, thus reducing the account's buying power. Even more important than that, though, is that the rise in the share price decreases the percent equity. If that percent falls below the critical level, a maintenance margin call will be forthcoming.

I've recently opened an IRA to do some investing in this bull market. Like a good Fool, though, I'd like to work both sides of the street, and go long and short. Am I permitted to use margin in my IRA?

You may not use margin, and therefore may not short stocks, in IRAs, SEP-IRAs, or Keogh plans. Under certain circumstances, you may do so in a 401(K) plan.

For an actual, real life description of a margin disaster, please read the post of a member of our Foolish Community: The Real, Real Risks of Margin.

Category: Forex

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