From time to time, I am asked how margin in the stock market works. Here is a simple explanation of how the basic leverage works. Margin is leverage and leverage magnifies both profits and losses. But, that is only part of the story . . .
Stock Goes Up $5.00 Per Share
Assume you purchase 1,000 shares of DEF priced at $10.00 per share. Your total purchase is $10,000 plus commission and fees. (For this example, we will assume there were no commissions or fees.)
You now owe the brokerage firm $10,000 on settlement date. (Trade day plus two). If you have previously established a margin account, you can pay as little as $5,000 of your money and borrow $5,000 from the broker-dealer. This borrowed $5,000 is called a debit balance and the broker-dealer will charge you interest at a rate that can be negotiable.
If DEF stock increases $5.00 per share moving from $10.00 per share to $15.00 per share, you could sell, repay the loan and pocket the profit. In this example you would have sold 1,000 shares of DEF at $15.00 per share or $15,000 proceeds. You borrowed $5,000 from the broker which ultimately needs to be paid back plus interest. Subtracting the debit balance from the proceeds you see that your original $5.000 investment became $10,000. The stock price grew by 50% and you earned profits of 100% (less interest, costs and fees).
Stock Goes Down $5.00 Per Share
Using the same example if the stock dropped to $5.00 per share, your investment would have a market value of $5,000. You owed $5,000 to your broker dealer for the margin debit. After paying off your debit balance, you have lost your entire investment plus costs and fees (. And, you still owe the broker-dealer interest on the borrowed funds.)
It’s More Complex than That!
The preceding is a simple example of how leverage works in the stock market. Margin investing is more complex than that. The Federal Reserve Board Regulation T provides the rules for broker-dealer extensions of credit. The broker-dealers and FINRA all have additional rules and policies related to margin. Anyone using margin needs to fully understand how the process works and be prepared to comply with all the rules.
Since it is possible for the investor to lose more money than he has on deposit, the brokerage firms vigorously enforce margin requirements and margin calls. The customer, by signing a margin agreement generally agrees to the following:
Margin Agreement Language
“You can lose more funds than you deposit in the margin account. A decline in the value of securities that are purchased margin may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securities or assets in your account(s).
- The firm can force the sale of securities or other assets in your account(s). If the equity in your account falls below the maintenance margin requirements or the firm’s higher “house” requirements, the firm can sell the securities or other assets in any of your accounts held at the firm to cover the margin deficiency. You also will be responsible for any short fall in the account after such a sale.
- The firm can sell your securities or other assets without contacting you. Some investors mistakenly believe that a firm must contact them for a margin call to be valid, and that the firm cannot liquidate securities or other assets in their accounts to meet the call unless the firm has contacted them first. This is not the case. Most firms will attempt to notify their customers of margin calls, but they are not required to do so. However, even if a firm has contacted a customer and provided a specific date by which the customer can meet a margin call, the firm can still take necessary steps to protect its financial interests, including immediately selling the securities without notice to the customer.
- You are not entitled to choose which securities or other assets in your account(s) are liquidated or sold to meet a margin call. Because the securities are collateral for the margin loan, the firm has the right to decide which security to sell in order to protect its interests.
- The firm can increase its “house” maintenance margin requirements at any time and is not required to provide you advance written notice. These changes in firm policy often take effect immediately and may result in the issuance of a maintenance margin call. Your failure to satisfy the call may cause the member to liquidate or sell securities in your account(s).
- You are not entitled to an extension of time on a margin call. While an extension of time to meet margin requirements may be available to customers under certain conditions, a customer does not have a right to the extension.”
Margin is not for everyone. Investors considering margin should thoroughly discuss the topic and increased risks with your financial advisor and review the following SEC information: