2) Margin Trading: What Is Buying On Margin?
Margin Trading is investing in stocks but this time it involves borrowing money from a broker to have more buying power. It allows you to buy more stock than what your own investment capital would permit.
As an example, let’s pretend that you have $15,000 in your margin account. Your buying power can go up as high as $30,000. If you buy stock valued at $10,000, you will have left $5,000 of your own deposit, and you even haven’t touched your margin. You only start borrowing once you buy stock that is worth over $15,000.
To start this kind of stock trading, you need to open a margin account. This is different from a regular cash account. The law is rather strict when it comes to margin accounts, so the brokerage must obtain your actual signature before the account can be opened. The initial deposit requirement for a margin account is higher than normal, which is set at $2,000, and some brokerages even require more. This deposit is called the minimum margin.
Once the account is ready, you can start buying stocks and borrow 10%, 20% or 35%, but not more than 50% of the purchase price of a stock. This is called the initial margin, the percentage of the purchase price of stocks which you must pay for with your own money. In some brokerages they will even require you to deposit more than 50% of the purchase price.
Not all stock, however, can be bought on margin. Penny stocks, initial public offerings (IPO), over-the-counter bulleting board securities (OTCBB), for example, can not be bought on margin. The restriction varies from any broker. It is best to ask your broker what they allow to be bought on margin. The Federal Reserve Bank also regulates which stock are marginable.
It is important to note that the buying power of a margin account will change on a daily basis. This is usually due to the price movement of the marginable securities in the account.
Unlike regular loans, the money you borrow from the brokerage doesn’t really have a definite time for you to pay back what you owe. However, once you sell stock in a margin account, the proceeds goes to the broker as payment for the loan until it is fully paid. There is also a restriction called the maintenance margin. This is the minimum balance requirement in the account. If you go below the minimum a margin call happens, and you are asked to deposit more funds or sell more stocks to pay off your loan.
The amounts for the initial margin and the maintenance margin are set by the Federal Reserve Board, and also by your brokerage. Some brokerages can have stricter limits. The Federal Reserve Board sets a minimum initial margin of 50% and a maintenance margin of at least 25%.
Then there is the cost of borrowing. Marginable securities in the account are made as collateral. Of course, the interest has to be paid too. The charges can be applied to your account, or you can make payments yourself. It is best to pay promptly, because as your debt increases, so will the interest charges.
Buying on margin is highly recommended for short-term investments. The longer you hold an investment on margin, the odds of you making a profit is against you.