when you buy a stock on margin you
essentially borrow money from your
broker to buy more stock and you use
that stock as collateral let's look at
an
example meet JN JN has $5,000 he would
like to invest in XYZ company John
strongly believes XYZ company is going
to move higher and he would like to
invest on margin he contacts his broker
to be sure that his account qualifies
for margin he intends to invest $5,000
of his cash in XYZ company he has a few
other Investments as well but we are
going to ignore those for this example
his broker approves him for a margin
account and they are satisfied with his
account balance since it is greater than
their minimum account balance for margin
accounts which in this case is
$2,000 first his broker explains there's
an initial margin requirement currently
that requirement is 50% and keep in mind
the initial margin requirement is set by
the Federal Reserve and they have the
right to change it whenever they want
although it is interesting to note that
the Federal Reserve has changed the
margin requirement 23 times since this
policy started back in 1934 but the
current rate of 50% was set in 1974 and
hasn't changed since then John jumps in
so this 50% initial margin requirement
this means that when I first get into an
investment I must put up at least 50% of
the cash needed for this position yes
the broker replies so with my $5,000 I
can purchase $10,000 worth of stock yes
exactly if you have a $10,000 position
in XYZ company the rule states you must
initially put up at least 50% which in
this case is
$5,000 so to use your example you bought
$110,000 worth of XYZ company and you
posted $5,000 to initiate the position
this satisfied the initial margin
requirement of 50% this means that at
the start of your investment you have
50% equity and 50% debt your 50% Equity
is from the XYZ shares that you own and
your 50% debt is the other $55,000 you
borrowed from your broker now it's
important to know that like all debt you
will be charged interest on this $5,000
debt so if your investment in XYZ
company Rises by 25% well then your
account is now worth $12
,250 and if you sold your XYZ company
shares right then ignoring any
commissions or interest charges you
would automatically pay back your broker
the $5,000 they let you borrow and you
would be left with
$7,500 and since you only put up $5,000
as an initial investment that means you
are up $2,500 on your $5,000 investment
which is a 50% return this is a good
example of why people use margin on
investments it helps amplify their
return turns but on the other hand if
the value of the stock Falls it is
possible you get what is known as a
margin call a margin call is a notice
from us your broker requiring you to
post more cash into your account John
once again jumps in with a question what
determines if I get a margin call or not
great question says the broker so the
initial margin requirement we discussed
before is how much you must initially
put up when you enter a margin position
but once you in the position what takes
over is known as as the maintenance
margin sometimes it's also called the
maintenance requirement this is
typically set by the stock exchange or
the broker not the Federal Reserve right
now the New York Stock Exchange usually
requires a minimum of 25% for a
maintenance margin but in our case our
brokerage firm requires a maintenance
margin of 35% but this can vary from
account to account and broker to broker
so going back to your example if your
$10,000 investment in XYZ company Falls
by 25% instead of rising by 25% well
then your account is now worth
$7,500 you still owed the $5,000 you
borrowed from the broker which means
your Equity position is only
$2,500 and since your $2,500 Equity is
only 33 and 13% of the entire
$7,500 value and that 33 and 1/3% is
less than our maintenance margin
requirement of 35% you will receive a
margin call if a margin call happens
you'll be required to deposit enough
cash into your account to get the value
back above the 35% maintenance margin
then John asks what happens if I can't
make a deposit well if you're unable or
unwilling to make a deposit then your
broker will sell your position and the
$55,000 margin debt you had will be paid
back to the broker immediately leaving
you with the remaining
$2,500 which turns out to be a 50% loss
on your XYZ investment as you can tell
margin has a way of magnifying returns
if you're doing well margins can make
your gains better but if you're losing
money margins can hurt your returns just
as
easily if you have any questions about
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