Investing in the margins

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We've all heard of the lucky investor who made a killing by not only buying Apple when it was cheap, but by buying it on margin, effectively doubling his already hefty returns. We've also heard of the not-so-lucky investor who made a bad call on margin, was forced to sell at a steep loss and then to liquidate his profitable holdings when he received a margin call.
The two stories are illustrative of the upside and downside of margin investing. Buying on margin means you're buying stocks with money you've borrowed from your brokerage firm. It's appealing because you might in theory turn a profit using money you don't even have. But it's risky in that you can lose big if prices fall.Footnote 1

How margin accounts work

To purchase a stock on margin, you first need to open a margin account. That's different from a typical brokerage cash account, although many brokerages will give you margin accounts automatically, unless you specifically tell them not to.
Margin accounts must adhere to certain rules stipulated by The Financial Industry Regulatory Authority (FINRA) and the Federal Reserve. These include a minimum balance of $2,000, a maximum 50% borrowing limit of securities purchased, and an account maintenance limit of 25%, which is the minimum amount of cash that must be held in a margin account relative to the value of the stocks. Brokerages can set different minimum account balances, margins and maintenance minimums, as long as they are more stringent than the federal rules.
The mechanics of buying on margin run as follows. Let's say you open a margin account with $10,000 and wish to use it to purchase $20,000 of XYZ Stock on 50% margin. That means that $10,000 of the purchase price will be funded out of your balance, and the other $10,000 will be funded by a loan. This loan will require collateral of $10,000, which means that half of your purchased shares will serve as collateral.
Not all securities are marginable. In general, penny stocks, over-the-counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) cannot be purchased on margin, and different brokerages have different restrictions. What's more, brokerages may set maintenance minimums to correspond with the volatility of a stock. For instance, a stock considered highly volatile might carry a maintenance minimum of 75%.

One margin, two scenarios

Our lucky Apple investor, flush with his recent success, next decides to buy two different stocks on margin. His first purchase, at a 50% margin, was $10,000 of Lucky Corp. shares. Lucky's share price then climbs 50%, at which point our savvy investor sells — walking away with a 100% profit. Proceeds of the sale are used in part to pay off the loan, but still leave him with a tidy profit even after trade commissions and interest expense on the loan are factored in.
His second purchase takes a different tack. He purchases $10,000 of Unlucky Corp., again on 50% margin, and the stock price immediately plunges 50%, following an unexpectedly bad earnings report. He liquidates his position, leaving him with a total loss of the $5,000 he invested, using the proceeds to pay off his loan.
The two transactions taken together might at first appear to be a wash, but when commissions and interest on the loans are factored in, he winds up in the red. What's more, if our investor had only executed the second (losing) transaction, he could have triggered a margin call, forcing him to sell other investments to meet maintenance minimums.
The takeaway here is that margin accounts are risky. They should be used in moderation, for limited positions, and for short time periods only — because even the pros are not good at guessing the market over time.

Footnote 1 Borrowing on margin may not be appropriate for every investor. An investment strategy that includes trading on margin exposes investors to additional costs, increased risks, and potential losses in excess of the amount deposited. Carefully review your investment objectives, financial resources, and risk tolerance to determine whether it is right for you. No one should buy on margin without the temperament to accept the price fluctuations that are intrinsic to the marketplace, and the financial resources to meet margin calls and absorb trading losses.

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