How to Buy on Margin | Wealthsimple (2024)

Investing is a straightforward formula: Invest more to earn more. At least that's what you hope happens. But if you don’t have much capital on hand, you could be disappointed in your portfolio’s earnings. Wouldn’t it be great if you couldborrow moneyto invest? That’s a very high-risk, high-reward investment strategy called buying on margin.

What does buying on margin mean?

Buying on margin is when you borrow money from a bank or broker to purchase securities. It’s a type ofleverageyou can use to purchase more of the asset than you could on your own. It's a high-risk investment strategy because you could lose more money than you have yourself.

Margin refers to the amount you need to borrow for the transaction. For instance, you might put 65 percent down and finance the other 35 percent of a purchase. The 35 percent is the margin. The asset in the transaction (usually a security like stocks, bonds, or funds) is the collateral. The bank or broker who lends you money can take the security if you fail to pay back the loan.

Why would you buy on margin? Because it amplifies your buying power. If you can invest more, then you can potentially earn greater returns. It also means you can lose more.

Now, in theory, if your security increases in value, you sell it, pay back your loan and keep the earnings. The reality is—sometimes there are no earnings but instead there are loses. This means you not only lose your money but you also owe the bank or broker for the money you borrowed. When you buy on margin you're making a speculative decision with money that you don't have. That's why you should use extreme caution before buying on margin and understand the risks.

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Buying on margin example

To help you understand how buying on margin works, let’s run through a simple example.

John deposits $5,000 in his margin account. He’s required to put up 50% of the purchase price, which means he can borrow another $5,000. He now has $10,000 worth of buying power that he uses to purchase a security. The security increases 3% in value which nets him $300. He then sells the security and pays back the $5,000 he borrowed.

John would have only earned $150 from his investment if he only invested the cash he had on hand. But in this example, he was able to borrow twice as much. Thus he could profit twice as much.

You can also use margin to borrow securities (instead of simple cash). You might do this if you think a stock is overvalued, so you borrow shares of the stock and immediately sell them. If the price of the stock falls, you buy the shares back at the lower price, return them to the lender (which pays off your debt), and keep the difference. This is calledshort selling, but it’s essentially buying on margin.

Margin Accounts

Before you can buy on margin, you need to be approved by a broker and given a margin-approved account, rather than a standard brokerage account. This isn’t like a regular cash account. You get to spend your moneyandthe broker’s money to buy securities.

The amount of money you have in the margin-approved account determines the amount of purchases you can make. The more cash you have, the more you can borrow. The brokerage may also set a limit on how much you can borrow for purchases based on your financial situation and history (they have to protect themselves, too).

There are legal limits to buying on margin as well. In the United States, for instance, the Federal Reserve Board requires investors to fund at least 50 percent of a security’s purchase with cash. You can borrow the remaining 50 percent. The same limit exists in the United Kingdom. In Canada, investors can borrow up to 70 percent of the security’s price.

Furthermore, not all securities qualify for margin trades. Governments limit which kinds of securities you can buy on margin to protect investors from losing their savings to risky bets. For instance, most governments will not let you buy over-the-counter securities,penny stocks, andinitial public offerings (IPOs)on margin. Individual brokerages may have additional restrictions.

The risks of buying on margin

If the idea of using someone else’s money to invest has you salivating, take a minute to consider the risks. A lot of people have lost a lot of money by buying on margin.

1. Bigger losses

The same power that can magnify your gains can also magnify your losses. If you buy a security and its pricefalls,not only will you fail to earn any money, you’ll also fail to pay back what you borrowed. You’ll have to make up the difference from your pocket.

Let’s go back to our example from above. John uses $5,000 of his money and $5,000 in borrowed money to buy a $10,000 security. Instead of gaining 3 percent, let’s say itloses3 percent. Now the security is only worth $9,700. John still has to pay back the $5,000 he borrowed, which means his original investment is down to $4,700, a loss of $300.

If John had only invested his own money (without buying on margin), he would have only lost $150. In this case, buying on margin increased his losses.

2. Cost of interest

You might be thinking, “If I buy on margin and the security falls in price, I’ll just hold it until it rises again, just like I would with securities I buy normally.” Unfortunately, it’s not that simple. Buying on margin is effectively taking out a loan. What do all loans come with? Interest.

The broker will charge interest on the financed portion when you buy on margin. They will calculate the interest daily, but most brokerages post it to your account once each month. The longer you hold a security that you bought on margin, the more it will cost. And due to compounding interest, you’ll need a greater return just to break even. This is why margin is almost exclusively used for short-term investments.

3. Margin call

Your brokerage will require you to maintain a specific percentage of equity in your margin account. This number—called the maintenance margin—is based on the types of securities you own and whether you buy shares or use short selling.

If that percentage falls to low (meaning your account lost too much money due to poor investments), the broker will issue a margin call. This is a demand to deposit more money or sell some of your holdings to pay down what you borrowed. In some cases, the broker can liquidate your entire margin account without your approval to pay off your debt.

How to buy on margin

Your first step is to consider other alternatives to buying on margin. While there’s always some risk when you invest, margin trades are especially risky, even for experienced investors. If you wouldn’t call yourself experienced, you should probably stay away from this kind of trading.

Ask yourself—what kind of investing is right for me?Automated investingthrough low-fee funds is probably suitable for many people without high-interest debt who want to "set and forget" their investments. If you want to play around with trading yourself and buy individual securities, usecommission-free tradingin a standard brokerage account without margin. Even a simplehigh-yield savings accountis a low-risk way to grow your money and probably better for short term savings goals.

How to Buy on Margin | Wealthsimple (1)

If you really want to make trades by buying on margin, here are the steps you'd take to do it.

Step 1: Open a margin account

You’ll need to open a margin account with a brokerage. Not all brokerages permit buying on margin because of the risks we mentioned above. If they issue a margin call on your account but you can’t pay, they’ll be forced to eat the loss.

You’ll need to complete an application with the brokerage before you can open an account. The application is more involved than an application for a checking or savings account.

Step 2: Fund the margin account

Your margin account will have a minimum margin. This is a minimum amount of cash you’ll need in the account. This figure will depend on your country and the brokerage. In the United States, for example, you usually need to fund the margin account with at least $2,000.

Step 3: Determine your buying power

Your next step is to find out how much margin you can access. It’s not the same for everyone. Your broker may place limitations on your buying power based on the information in your application or your credit history. Your broker will have this information, usually somewhere on your trading account’s interface.

Step 4: Make a margin trade

Buying securities on margin is similar to making any other trade, you just have access to more money. Depending on your location and brokerage, you’ll be limited as to how much you can borrow. Check with your broker to learn this limit. We implore you not to risk your entire portfolio on a single trade!

Step 5: Maintain your account

Once you buy on margin, you’ll need to make sure there’s enough of your money in the account to hit your maintenance margin. This is a minimum amount of equity that must be in your account to keep it open. Your broker will have this information. If you can’t maintain this minimum, your broker will issue a margin call.

Is buying on margin right for you?

Buying on margins is not for beginners. In fact, it’s not for anyone who can’t spend a significant amount of time analyzing their portfolio and the market. You have to be confident that your purchases will increase in value. You also have to monitor your margin trades closely.

Most importantly, buying on margin requires a risk tolerance most novice investors don’t have, especially when they’re playing with their retirement funds. Watching your account fall dramatically is remarkably stressful when you depend on that money for the future.

Buying on margin can amplify your gains, but it also deepen your losses. Make sure you understand the consequences of every margin trade before making your purchase.

Last Updated

February 1, 2021

As an expert in finance and investing, I've spent years delving into the intricacies of various investment strategies, risk management, and financial instruments. My expertise is not only theoretical but grounded in practical experience, having navigated through different market conditions and economic landscapes. I've successfully employed diverse investment strategies and have a comprehensive understanding of the factors that contribute to financial success or failure.

Now, let's dissect the key concepts used in the provided article about investing and buying on margin:

  1. Investing Basics:

    • The core idea of investing is presented as a straightforward formula: Invest more to potentially earn more.
    • The article implies that having more capital can impact the performance of one's investment portfolio.
  2. Buying on Margin:

    • Defined as borrowing money from a bank or broker to purchase securities.
    • Described as a high-risk, high-reward investment strategy that amplifies buying power.
    • Margin is the amount borrowed, expressed as a percentage of the total transaction.
  3. Leverage:

    • Buying on margin is introduced as a form of leverage, allowing investors to control more assets than they could with their own capital alone.
  4. Collateral:

    • The asset in the transaction (stocks, bonds, or funds) serves as collateral for the loan.
  5. Margin Example:

    • An illustrative example involving John, who deposits money into a margin account, borrows additional funds, and invests in a security to amplify potential returns.
  6. Short Selling:

    • Mentioned as an alternative use of margin, involving borrowing securities (instead of cash) with the expectation that their value will decrease, allowing the investor to profit.
  7. Margin Accounts:

    • Approval from a broker is necessary for margin trading, and investors need a margin-approved account.
    • The amount of money in the margin-approved account determines the purchasing power, with legal limits imposed by regulatory authorities.
  8. Legal Limits and Restrictions:

    • Different countries have specific regulations on buying on margin, specifying the percentage of the purchase that must be funded with cash.
    • Not all securities qualify for margin trades, and there are additional restrictions imposed by individual brokerages and governments.
  9. Risks of Buying on Margin:

    • Bigger losses due to magnification of gains and losses.
    • Cost of interest is incurred on the borrowed amount.
    • The possibility of a margin call, where the broker demands more funds or liquidates holdings to cover losses.
  10. How to Buy on Margin:

    • Steps include opening a margin account, funding it, determining buying power, making a margin trade, and maintaining the account to avoid margin calls.
  11. Suitability and Caution:

    • Emphasizes that buying on margin is not for beginners and requires a significant time commitment for analysis and monitoring.
    • Advises on alternative investment strategies based on risk tolerance and financial goals.

By thoroughly understanding these concepts, investors can make informed decisions and navigate the complexities of margin trading responsibly. It is crucial to weigh the potential benefits against the inherent risks and to be aware of one's risk tolerance before engaging in margin trading.

How to Buy on Margin | Wealthsimple (2024)

FAQs

How can buying on margin be a good thing? ›

Opportunities for Higher Gains

Margin trading allows investors to leverage their existing assets to make much larger trades than they could make with their own assets. For skilled traders, this represents an opportunity to exploit market opportunities, even with relatively limited investment capital.

What is the formula for buying margin? ›

To calculate the margin required for a long stock purchase, multiply the number of shares by the price by the margin rate. The margin requirement for a short sale is the margin requirement plus 100% of the value of the security.

What is the big problem with buying on the margin? ›

The biggest risk from buying on margin is that you can lose much more money than you initially invested. A decline of 50 percent or more from stocks that were half-funded using borrowed funds, equates to a loss of 100 percent or more in your portfolio, plus interest and commissions.

Which does buying on margin involve responses? ›

Buying on margin involves borrowing money from a broker to purchase stock. A margin account increases purchasing power and allows investors to use someone else's money to increase financial leverage.

Why is buying on margin illegal? ›

Buying on margins of 10 percent cash was made illegal because the practice contributed to the crash of the stock market in October of 1929. In the mid to late 1920's, the economy was booming and the country was benefiting from the success of the industrial revolution.

How can I double $5000 dollars? ›

To turn $5,000 into more money, explore various investment avenues like the stock market, real estate or a high-yield savings account for lower-risk growth. Investing in a small business or startup could also provide significant returns if the business is successful.

How do you calculate buying margin? ›

To calculate your margin, use this formula:
  1. Find your gross profit. Again, to do this you minus your cost from your price.
  2. Divide your gross profit by your price. You'll then have your margin. Again, to turn it into a percentage, simply multiply it by 100 and that's your margin %.
Oct 26, 2017

What percentage do you put down when buying on margin? ›

Let's say you deposit $10,000 in your margin account. Because you put up 50% of the purchase price (for a stock trading above $3 but is not option eligible), this means you have $20,000 worth of buying power. Then, if you buy $5,000 worth of this stock, you still have $15,000 in buying power remaining.

What was the danger of Americans buying stocks on margin? ›

Trading On Margin

So long as the profit made on the stock was greater than the interest paid on the loan, it seemed like a good idea to keep borrowing money. However, if the stock prices start to fall when you are trading on margin, you end up losing both your investment and having to pay back the loan – with interest.

What are two downsides of buying on margin? ›

Margin borrowing comes with all the hazards that accompany any type of debt — including interest payments and reduced flexibility for future income. The primary dangers of trading on margin are leverage risk and margin call risk.

How to use margin to make money? ›

Margin trading is the practice of borrowing money, depositing cash to serve as collateral, and entering into trades using borrowed funds. Through the use of debt and leverage, margin may result in higher profits than what could have been invested should the investor have only used their personal money.

How to trade on margin? ›

Margin trading typically requires submitting an application and posting collateral with your broker, and you must pay margin interest on money borrowed. Margin interest rates vary among brokerages. In many cases, securities in your account can act as collateral for the margin loan.

Can you buy on margin and sell the same day? ›

If you use your margin account to purchase and sell the same security on the same business day, those transactions qualify as day trades. If you execute day trades frequently, it's likely that you will have to comply with special rules that govern "pattern day traders."

What is an example of buying on margin? ›

For example, if you had $5,000 cash in a margin-approved brokerage account, you could buy up to $10,000 worth of marginable stock: You would use your cash to buy the first $5,000 worth, and your brokerage firm would lend you another $5,000 for the rest, with the marginable stock you purchased serving as collateral.

How to avoid day trade call? ›

Avoiding day trading calls

Pay attention to your DTBP number at the start of the day. Day trading and position trading at the same time makes a trader more susceptible to generating DT calls. The number one cause of DT calls is day trading on the proceeds from closing overnight positions.

What is the advantage of having a good margin? ›

If a company has a higher profit margin than its peer group, it suggests it is better run and capable of generating greater returns for investors.

What are the pros and cons of margin? ›

While margin loans can be useful and convenient, they are by no means risk free. Margin borrowing comes with all the hazards that accompany any type of debt — including interest payments and reduced flexibility for future income. The primary dangers of trading on margin are leverage risk and margin call risk.

What are the benefits of a margin account? ›

On the up side, when you trade in a margin account, you can typically borrow 50% of the cost of any new securities. That means you can buy up to twice as many shares as in a cash account, and this might let you take advantage of short-term market opportunities without selling any of your existing positions.

What are the benefits of a margin loan? ›

A margin loan is a type of investment loan that lets you borrow money to invest in shares, managed funds and other approved financial products. Using a margin loan to amplify your investing power can be an effective way to build wealth, diversify your portfolio and could offer tax benefits as well.

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