What in the world is margin?
Margin is money that you borrow from your broker to buy stocks. It's a secured loan, basically, where the collateral is the existing marginable securities in your account. How much you can borrow is determined by how much is in your account.
One quick point -- not all securities are marginable. What this means is that there are some categories of stocks -- usually those priced below $5 a share, as well as initial public offerings (IPOs) for a certain period of time after their debut, and some Nasdaq stocks -- that your broker will not lend you the money to buy. If you want to buy something that is not marginable, you'll have to put up all the money yourself.
Margin, in a lot of ways, works like a credit line issued to you by your broker. In fact, to quote online discount broker Ameritrade, "Having a margin account is like having a pre-approved credit line with your broker." Woo hoo! Party at my house... wait, not so fast! There are aspects of margin credit that differ dramatically from pure credit. We'll get to those differences in a bit. Even without addressing the differences, Fools know that credit is a tricky thing, not to be toyed with.
Just like with a credit card, you're charged interest for the privilege of using the firm's money. While the rates charged for margin are lower than the rates you'll pay to a credit card company, you should still remember that this isn't free money. (Margin rates typically go down as you borrow more, which puts an interesting twist on things, when you think about it.)
OK, so margin is sort of like a loan, and sort of like a credit line. How does it actually work?
The Federal Reserve Board regulates the amount of credit brokerages are allowed to extend to their clients. Currently, the law says you can borrow up to 50% of the value of your marginable securities. Another way to look at this is to say that, for stock purchases, you put up 50% of the price, and your broker puts up 50%. This all sounds a little confusing, I know, so let's introduce some numbers here to help explain it.
Let's say you have $10,000 in your margin-approved brokerage account. This allows you to purchase up to $20,000 of marginable securities. It gives you $20,000 worth of "buying power."
Suppose there is a marginable stock that costs $10,000 per share. You could, if you wanted to, buy two shares of that stock. You'd put up 50% of the purchase price for two shares at $10,000 apiece ($20,000), and your broker would put up 50%.
One thing to remember about margin is that the amount you can borrow is not a fixed number. In this respect, margin differs from the static credit limit given for your credit cards. Margin is tied to the value of the marginable securities in your portfolio. Therefore, your buying power changes daily, along with the changes in your stocks' prices. If your portfolio goes up, the amount you can borrow increases. We'll get to what happens when your portfolio goes down later.
Are there rewards to using margin? What are the risks?
Margin has a magnifying effect on the gains and the losses in your portfolio. Let's look at some numbers again to illustrate this very important point.
Starting with the $10,000 in your margin account, you want to buy 1,000 shares of a stock that costs $20. You will therefore borrow $10,000 from your broker. Say your order gets filled at exactly $20 a share and you pay no commissions on that trade. The total invested is $20,000 ($10,000 from you and $10,000 from your broker for 1,000 shares of a $20 stock).
Let's imagine that the stock goes up over the next year to $45 a share. The value of your total investment has gone from $20,000 to $45,000. You sell your shares and pay back your broker's margin loan of $10,000 plus interest, leaving you with close to $35,000. Somewhere around $25,000 of that is profit for you.
If you'd just bought 500 shares of the stock at $20, not using any margin from your broker, your investment after the stock rose would be worth $22,500, with $12,500 of that being profit to you. In the case where margin was used, you essentially made $25,000 on an investment of $10,000, as opposed to making $12,500 on the same $10,000. (Remember that, in this example, for simplicity's sake, we didn't take out the necessary commissions, margin interest, or the capital gains taxes that you'd have to pay in real life.)
This might sound like a dream come true, but remember it cuts the other way, too, and sometimes viciously. Just as margin can pump up your gains when a stock goes up, it can just as easily make your losses greater when a stock goes down.
Let's look at the other side of the coin. Imagine that your $20 stock falls to $15 over the next year. In the margin situation, your $20,000 investment has fallen to $15,000. You sell the stock and pay back your broker's $10,000 loan plus interest (remember, you have to pay interest on your margin debt regardless of whether your securities go up or down). You are left with somewhere around $5,000 of your original $10,000.
If you hadn't used margin and had just purchased 500 shares of the stock at $20 per share, after it fell to $15 you'd be left with $7,500 of your original $10,000. Using margin, you'd lose $2,500 more than you would if you didn't. As you can see, margin only makes sense when your portfolio is going up. And, you're always paying interest for it, regardless. (By the way, if you can guarantee me that your portfolio is always going to go up, I have some sweet seaside land in Colorado I'd like to offer you.) If you bet wrong, you'll pay for it -- both in magnified losses and in margin interest.
What about the dreaded margin call?
Related to the magnification of losses attributable to margin is the harsh reality of the margin (or maintenance) call. A margin call occurs when the value of the collateral you put up for the loan (i.e., the marginable securities in your portfolio) falls below a predetermined minimum requirement. Usually, this requirement is about 30% of the loan. In English, if the stocks in your portfolio (the collateral for the margin) fall to a level that is below 30% of the amount loaned to you by the broker, your broker will contact you wanting more collateral. The equity in your account (that is, the market value of your securities, minus the amount loaned to you by your broker) must stay above this minimum requirement.
Let's use some numbers again to get a better grasp on this. Taking our 1000 shares of the $20 stock bought on margin, imagine the price falls to $13 a share. At this point, the $20,000 investment is worth $13,000. Remember, you and your broker each put up 50% of the money, but you have to pay back what you borrowed. So, $10,000 of that $13,000 is the broker's.
The remaining $3,000 in equity is 30% of the amount of the loan. If the stock falls any more, you're likely to get a margin call from your brokerage. At this point, you'll have to send additional collateral to fulfill the minimum requirement. The additional collateral can either be cash or other fully marginable securities. Only a percentage of the market value of a security can be used to meet your margin call, though.
What if you can't meet your margin call by sending cash or other securities? Your brokerage can then sell the margined securities in your account to cover it. You gave them this right when you signed the agreement to open a margin account.
Sometimes, too, a volatile stock can drop so rapidly that your broker will sell your shares at the worst possible time, and leave you not only shareless, but also owing them additional funds. This is where the risks of margin outweigh any benefits.
Some final thoughts on margin
Investing involves risk. Nothing is guaranteed. However, as smart and Foolish investors, we seek to temper as much risk as we can. Margin is one risk you don't have to take. You can simply avoid it.
If you do choose to use margin, watch out. Remember the risks involved. We like to suggest that you don't borrow more than 20% of your portfolio. Don't get greedy and use the maximum amount of margin available to you. There's no need to play with fire to that extent, and that's what margin ends up being for many investors -- overtaking and consuming their portfolios before they realize what hit them.
Benjamin Franklin said, "Experience is a dear teacher, but fools will learn at no other." Well, Mr. Franklin, fools perhaps, but not Fools. Prove him wrong and don't wait until margin burns you to conclude that you've been using too much of the stuff, or that you shouldn't have been using it at all.
How do you feel about margin? Have you had any experience with it? Talk about it with other Fools on our Specials discussion board.