Definition
Buying on margin is a finance strategy that involves borrowing money from a broker to purchase more stock than you can afford with your available funds. Here, your margin account acts as collateral against the loan. It allows an investor to pay only a fraction of the full cost of the stock, boosting potential profits but also increasing losses if the investment value drops.
Key Takeaways
- Buying on Margin refers to the practice of buying an asset where the buyer pays a percentage of the asset’s value and borrows the rest from the bank or broker. The margin is the part of the purchase price that the investor must contribute.
- This method can significantly increase potential profit since it allows investors to purchase more assets than they could afford. However, it also carries greater risk because if the assets’ value decreases, the investor may not be able to repay the loan.
- Moreover, if the market becomes volatile, brokers may issue margin calls requiring investors to deposit more money. If investors fail to meet the margin requirement, the broker could potentially sell the securities without notification.
Importance
Buying on Margin is a crucial finance term because it refers to the practice of borrowing money to purchase securities, stocks being the most common.
This method magnifies the potential for profit as well as risk, making it a key strategy for more aggressive investors.
Buying on margin allows investors to buy more stocks than they could typically afford, presenting the opportunity for greater monetary gain if the stock price increases.
However, if the price decreases, the investor still has to pay back the loan with interest, which can potentially lead to significant financial losses.
Therefore, understanding the concept of buying on margin is important for anyone involved in investment activities, because it directly influences both the potential for profit and risk exposure.
Explanation
Buying on margin serves as a method in finance which allows investors to purchase securities by borrowing a significant portion of the purchase amount from their broker. Its main purpose is to amplify the potential profits from an investment. The margin is the difference between the total value of securities held in an investor’s account and the loan amount from the broker.
Buying on margin utilizes borrowed money to leverage larger positions than would be possible using only the investor’s own funds. This strategy can significantly increase profit potential if the security’s price increases. But on the other side, it also comes with a high level of risk, as it equally magnifies losses if the investment does not perform well.
Investors should fully understand this risk before considering buying on margin. Moreover, the brokerage firm may require an investor to deposit additional funds or securities into the account as collateral to cover potential losses, called a margin call, if the securities decline significantly in value. This is intended to ensure that the investor can repay the borrowed money.
Examples of Buying on Margin
Stock Market Investment: Perhaps the most common example of buying on margin is in the stock market. A trader may not have the entire amount needed to purchase the shares he wants. So, he borrows the additional amount needed from his broker. The shares purchased serve as collateral on the loan. If the value of the shares increases, the trader can sell the shares, repay the broker, and keep the profit.Real Estate Purchase: Let’s say there’s a property worth $100,000 that a buyer believes will rise in value to $120,
However, they only have $50,They can take a mortgage on the property for the remaining $50,000, with the property itself serving as collateral. If the property does rise in value as expected, they can sell it, repay their mortgage, and keep the profit. This could be seen as buying on margin.
Day Trading: Day traders often buy on margin to capitalize on short-term price fluctuations in highly liquid stocks or indices. Here’s how it works: A day trader might have $1,000 in their margin account. However, because they’re classified as pattern day traders, they have a margin limit of 4:This allows them to buy up to $4,000 worth of securities in a day- even though they only have $1,
If the securities increase in price during the day, they can sell them for a profit. They then return the borrowed money, and their account shows the profit minus the original $1,
FAQs for Buying on Margin
What does Buying on Margin mean?
Buying on Margin refers to the process of borrowing money from a brokerage firm to purchase additional securities. This leverage technique allows investors to control larger positions with a smaller amount of cash.
How does Buying on Margin work?
When an investor decides to buy on margin, they borrow money from their broker to cover part of the cost of the investment. The securities in the investor’s account act as collateral for the loan. The marginable securities in the investor’s account are determined by federal regulation and the policies of the brokerage firm.
What are the risks involved in Buying on Margin?
Buying on Margin comes with considerable financial risk. If the value of the securities drops significantly, the investor may receive a margin call from the broker, demanding either additional cash or a portion of the securities to be sold. If the investor cannot meet the margin call, the broker may sell the securities in the account, potentially causing loss.
What are the benefits of Buying on Margin?
Despite the risks, buying on margin can enhance portfolio returns when investments perform well. This is because investors control a larger amount of securities with a smaller amount of cash. Therefore, any rises in the value of the securities can result in larger profits. However, this is a high-risk strategy and should only be employed by experienced investors.
Related Entrepreneurship Terms
- Margin Account: An account that an investor holds with a broker, which allows them to buy securities on credit
- Broker: An individual or firm that facilitates the buying and selling of investments
- Margin Call: A broker’s demand for an investor to deposit additional money or securities into their margin account when the value of the account falls below a certain level
- Collateral: Security in the form of an asset or property offered against a loan
- Leverage: The use of borrowed money to increase potential return on investment
Sources for More Information
- Investopedia: An extensive digital resource for investing, wealth management, and finance education, it includes a comprehensive definition and explanation of Buying on Margin.
- U.S. Securities and Exchange Commission (SEC): This government agency oversees securities transactions, activities of financial professionals and mutual fund trading to prevent fraud and intentional deception.
- MarketWatch: Offers up-to-date financial news, analysis and stock market data, with thorough articles about Buy on Margin, including its risks and advantages.
- Bankrate: Provides expert advice and tools for mastering personal finance, it contains in-depth articles about Buying on Margin.
