Buying on margin
- While trading on margin may magnify your investment returns, it may also magnify your investment losses.
- You should be aware that a brokerage can set its own rules on margin financing and margin call procedures.
- Your brokerage may not be obliged to make a margin call before it cashes in securities held in your account. The forced liquidation may not occur at a price or time that is favourable to you.
What is margin financing?
An investor who purchases securities may pay for the securities in full or may borrow part of the purchase cost from his brokerage. If you choose to borrow money, you have to open a margin account. The portion of the purchase cost that you deposit is called "margin".
Your credit facility is secured against the purchased securities or other securities held in your margin account as collateral. It is entirely up to the brokerage to determine your margin requirements on the basis of your personal circumstances and the securities collateral provided by you. In other words, your brokerage assesses your financial capability, as well as the liquidity and volatility of the securities collateral concerned. For instance, the margin ratios on blue chips are likely to be higher than on other stocks.
After selling the securities, you have to repay the borrowed money in accordance with the terms of the margin facility. The profit is the difference between the purchase cost and the sale proceeds, reduced by transaction costs and the interest charged on the margin loan.
Why trading on margin?
Investors generally use margin to increase their purchasing power and leverage their investments, i.e. to magnify the returns on their investments. Despite the possible higher gains, however, investors who trade securities on margin may potentially incur higher losses.
Suppose you buy a stock for $100 and the stock price rises to $150. If you pay for the stock in full, you will make a 50% gain on your investment. But if you buy the stock on 50% margin, i.e. paying $50 in cash and borrowing $50 from the brokerage, you can end up with a 100% gain on the money you invested.
However, the downside to margin trading is that if the stock price falls, a substantial loss will happen. Suppose the stock purchased for $100 drops to $50. If you pay for the stock in full, you will lose 50% of your stake. But if you buy on 50% margin, you will suffer a 100% or total loss! Don't forget that leverage works both ways!
Apart from the potential for greater losses, trading on margin may incur the risk arising from "margin calls". If the value of the securities held on the margin account falls below a pre-specified lending ratio, the brokerage may call for further collateral. If you fail to meet the "margin call", the brokerage has the right to "cash in" the securities held on your account. The brokerage will also determine the amount of time that you are allowed to make up the shortfall, depending on its own guidelines.
You should notice that your brokerage may not be obliged to make a margin call or otherwise tell you that the value of the securities held on your account have fallen below the specified lending ratio. Your brokerage may sell your securities at any time without consulting you. Under some margin agreements, even if your brokerage offers to give you time to raise the collateral in your account, the firm can sell your securities without waiting for you to meet the margin call. It is unlikely that the "forced liquidation" will occur at a price or time that is favourable to you. Furthermore, if you have more than one stock as collateral, your brokerage may sell the most liquid ones - not what you may have wanted to sell. Therefore, make sure to check the margin call procedures before you start trading.
You should also know that it is possible for you to lose more than your margin deposit under forced liquidation. For instance, if the proceeds from forced liquidation are insufficient to cover the margin loans, you will not only lose all your margin deposit but will also be liable to the remaining shortfall in your account.
Before you start trading on margin, you must have a clear, written contractual agreement in place. You must carefully review the agreement on margin facility before you sign it. Make sure you understand the terms and conditions of the margin account such as:
- Charges or deposits for opening a margin account, if any;
- How the interest on the margin loan is calculated;
- When and how the loan must be repaid;
- Usage of collateral permitted by client's authorisation;
- The lending ratio, or the margin requirement, and whether there are different lending ratios for different types of securities;
- The margin call procedures, e.g. when a margin call will occur, how the firm will notify you, when you should meet the call;
- What notice, if any, the brokerage will give you before selling your securities to cover the margin deficiency;
- How the brokerage will inform you of transactions in your account and the interest charges;
- How the brokerage can contact you for margin calls, forced liquidation, transaction notifications, etc when you are out of town.
You should note that brokerages have the right to set their own terms and conditions for margin loans. Each brokerage has its own policy and the terms may be stated in the client agreement. Some brokerages may post their policies on their company web sites. Practices for margin financing are hardly uniform in the securities industry.
You are advised to shop around and choose a brokerage that suits your needs. Read the client agreement to find out the margin trading terms, interest charges, margin ratio, margin call policy and the circumstances under which your position may be closed out without your consent. Seek clarification from your brokerage if in doubt.