A Message from Kimberly Clouse, Financial Expert:
I have worked in the financial services industry for nearly a decade in many capacities, most recently as a financial adviser for individuals. Over the course of my career, I have had the privilege of working with a diverse range of people, from the single mother just starting her own business to the dot.com billionaire. Based upon my experiences, I have learned that the same basic principles and lessons apply to a successful and healthy financial life, whether you’re starting out or cashing out. These guiding principles include simplicity, a long-term perspective, and above all, knowing that you have control of your financial destiny, and all the information you need is well within your reach.
Buying on Margin
Margin accounts, margin calls, and shorting stocks. What are these and how are they related? A margin account is a brokerage account in which a customer can buy securities with money borrowed from the broker. An investor must have a minimum amount of cash or securities deposited with the broker–the amount is referred to as the “margin”–when buying stocks on margin or shorting stocks. An investor typically establishes a margin account when she wants to either (1) buy stocks on margin or (2) short stocks.
Buying Stocks on Margin
When an investor buys stocks on margin, she is expecting the price of the security to rise. Suppose the investor wants to buy 1000 shares of Acme Corporation stock at the current market price of $5 per share. To purchase these shares, she would need $5000 plus any commissions charged by the brokerage. However, if she were to buy on margin, she would borrow up to 50% of the purchase price ($2,500) and pay the remaining $2,500 out of pocket. If Acme stock performs well, she earns all of the gains on the $5,000 investment even though half of the purchase price was borrowed. As long as the gains on the portion bought on margin–$2,500 in this example–exceed all borrowing costs, then the investor has benefited by buying on margin. There is typically no set time by which the investor must repay the margin loan, but eventually, of course, the investor must reimburse the broker for the funds borrowed and pay interest (based on the broker call rate).
What if the value of Acme declines? If the stock price falls below a certain level, then the investor might get a margin call from the brokerage asking her to contribute more cash or securities to her account–essentially to serve as loan collateral. When the margin account is established, the broker informs the investor of the required minimum ratio of marginable securities to securities owned outright. If the stock price falls and the ratio is not maintained, then the brokerage firm will issue a margin call to the investor, instructing her to cover the amount of the decline.
When an investor shorts a stock, she is hoping that the price will decline. When shorting a stock, an investor borrows shares, sells them immediately, waits for the price to fall, and then buys them back at the lower price to return to the broker. The attraction of shorting stocks is that an investor can make a profit without initial cash investment. The risk is that the stock price could rise instead of fall, and the investor could theoretically be exposed to unlimited loss potential since stocks have no maximum price. Because shorting stocks involves unlimited risk, the Securities and Exchange Commission requires brokers to issue margin calls when an investor’s losses reach a predetermined amount.
The minimum margin requirement is 50% of the purchase or short sale price for initial transactions, with a minimum of $2,000. The percentage that the investor is required to deposit is set by the Federal Reserve Board and can change from time to time. The amount required is frequently referred to as the “RegT” percentage, and RegT applies to each new margin purchase the customer makes.
The Federal Reserve, National Association of Securities Dealers (NASD), stock exchanges such as the New York Stock Exchange, and individual brokerages impose minimum maintenance (as opposed to initial) requirements. For most securities, the maintenance requirement is 25% of the securities’ total market value in equity. Certain volatile stocks, or special maintenance stocks, carry a 50% maintenance requirement.
A brokerage firm may only extend credit on securities that are deemed “marginable” by the U.S. Federal Reserve Board. Marginable securities generally include securities traded on the major U.S. exchanges that sell for at least $5 per share, many over-the-counter (OTC) stocks, government and municipal bonds, and certain other securities. Margin is applicable to U.S. securities only. Because of the inherent risks in margining securities, investors are not permitted to trade on margin in retirement accounts.
This column is designed to provide accurate and authoritative information on the subject of personal finances. It is provided with the understanding that the Author is not engaged in rendering legal, accounting, or other professional services by publishing this column. As each individual situation is unique, questions relevant to personal finances and specific to the individual should be addressed to an appropriate professional to ensure that the situation has been evaluated carefully and appropriately. The Author specifically disclaims any liability, loss or risk which is incurred as a consequence, directly or indirectly, of the use and application of any of the contents of this work.