Definition
‘On Margin’ denotes a method in securities trading where an investor borrows funds from a broker to purchase securities. The investor pays a part of the purchase price and the broker lends the rest. This borrowed amount is collateralized by the purchased securities and possibly other securities in the investor’s brokerage account.
Examples
- Stock Purchase: If an investor wants to buy $10,000 worth of stock but only has $5,000, they can purchase the stock on margin. The broker loans the remaining $5,000, using the $10,000 worth of stock as collateral.
- Intraday Trading: Suppose an active trader buys stocks on margin in the morning and sells them by the end of the trading day at a profit, repaying the borrowed funds and keeping the profit.
Frequently Asked Questions (FAQs)
1. What are the risks of trading on margin?
Trading on margin can amplify both gains and losses. If the value of the borrowed securities decreases, investors must cover the margin call by depositing more funds, or the broker might sell their securities to reduce the risk.
2. How much margin can I use?
This depends on the regulations in your country and the specific broker’s policies. Typically, brokerage firms allow up to 50% margin for purchasing securities.
3. What is a margin call?
A margin call occurs when the value of the securities in the margin account falls below a certain level, prompting the broker to demand additional funds or sell some assets to bring the account back to an acceptable level.
4. What are the interest rates for margin loans?
Interest rates on margin loans vary among brokers and depend on the amount borrowed and market conditions. They generally range from 3% to 8%.
5. Can I use margin in other types of accounts?
Margin is typically used in individual and joint brokerage accounts but not in retirement accounts like IRAs because of regulatory restrictions.
- Margin Call: A demand by a broker that an investor deposits additional money or securities to cover potential losses.
- Leverage: The use of borrowed capital to increase the potential return of an investment.
- Collateral: An asset pledged to a lender to secure a loan.
- Initial Margin: The percentage of the purchase price of securities that an investor must pay for with their own funds.
- Maintenance Margin: The minimum account balance required to keep an open position.
Online References
Suggested Books for Further Studies
- “Margin Trading from A to Z” by Michael Sincere
- “The Ultra Wealthy Investor” by John-Victor Louis
- “Security Analysis” by Benjamin Graham and David L. Dodd
- “The Essays of Warren Buffett: Lessons for Corporate America” compiled by Lawrence A. Cunningham
Fundamentals of On Margin: Investment Strategies Basics Quiz
### What is meant by purchasing securities 'on margin'?
- [ ] Buying securities only with available funds.
- [ ] Participating in a joint investment venture.
- [x] Purchasing securities by borrowing funds from a broker.
- [ ] Purchasing government bonds.
> **Explanation:** Purchasing securities 'on margin' involves buying securities by borrowing funds from a broker, allowing the investor to leverage their initial capital.
### What is the primary benefit of trading on margin?
- [ ] It guarantees no financial loss.
- [x] It allows investors to purchase more securities than they could with available funds.
- [ ] It offers lower transaction fees.
- [ ] It avoids the regulatory limitations of securities laws.
> **Explanation:** The primary benefit of trading on margin is that it enables investors to buy more securities than they could with their own funds, potentially amplifying their gains.
### What does a margin call require an investor to do?
- [ ] Withdraw funds from their account.
- [ ] Close their account immediately.
- [x] Deposit additional funds or sell securities to cover potential losses.
- [ ] Switch to a different broker.
> **Explanation:** A margin call demands that an investor either deposits additional funds or sells some of their securities to maintain the required account balance.
### What is the usual percentage limit for initial margin set by brokers?
- [ ] 25%
- [ ] 35%
- [x] 50%
- [ ] 65%
> **Explanation:** Brokers typically allow up to 50% of the purchase price of securities to be borrowed, which is the initial margin limit.
### What kind of risk is most associated with margin trading?
- [ ] Inflation risk
- [ ] Currency risk
- [x] Increased potential losses due to leverage.
- [ ] Regulatory risk
> **Explanation:** Margin trading significantly amplifies potential losses due to leverage, thereby increasing financial risk.
### What type of account typically does not permit margin trading?
- [x] Retirement accounts like IRAs
- [ ] Individual brokerage accounts
- [ ] Joint brokerage accounts
- [ ] Corporate accounts
> **Explanation:** Retirement accounts such as IRAs typically do not allow margin trading due to regulatory restrictions.
### When trading on margin, what happens if the value of the borrowed securities decreases?
- [ ] The broker reduces interest rates.
- [ ] The margin loan is forgiven.
- [ ] The investor receives a dividend.
- [x] The investor might face a margin call and need to deposit more funds.
> **Explanation:** If the value of the securities decreases, the investor might receive a margin call, requiring them to deposit additional funds to cover potential losses.
### How do interest rates for margin loans typically compare to regular loans?
- [ ] Higher than credit card interest rates.
- [x] They are generally lower but vary depending on the brokerage firm.
- [ ] Higher than mortgage rates.
- [ ] The same as government treasury rates.
> **Explanation:** Interest rates for margin loans are generally lower than those for credit cards but vary among brokers and market conditions. They are usually between 3% to 8%.
### What does 'maintenance margin' refer to?
- [ ] The initial capital required to start a margin account.
- [ ] The balance required to close a position.
- [x] The minimum account balance required to keep an open position.
- [ ] The maximum borrowing capacity in a margin account.
> **Explanation:** Maintenance margin is the minimum account balance that must be maintained to keep an open position and avoid a margin call.
### What action can a broker take if a margin call is not met?
- [ ] Increase the investor's borrowing limit.
- [ ] Close the investor's account immediately.
- [ ] Shift the investor to a new margin plan.
- [x] Sell sufficient securities to cover the margin deficit.
> **Explanation:** If a margin call is not met, the broker has the right to sell securities in the investor's account to cover the margin deficit.
Thank you for exploring the concept of trading ‘On Margin’ and for testing your knowledge with our fundamental investment strategies quiz. Keep leveraging your learning for better financial decisions!
