If you are new to stock trading, you have a lot to learn and one of the things that you need to know is buying stock on margin. Newcomers and amateur stock investors are not recommended to start out with leveraged buying as it can be risky. In this article I explain what buying securities like stocks on a margin means.
What is Buying Stock on Margin?
To put in simple words when an investor borrows money from his stock trader to buy some stock, he is said to have bought stock on margin. It is a loan granted by a stock broker to an investor for trading stocks that are marginally beyond his or her financial reach. This is a technique used to buy any kind of security, other than stocks. It is a leverage to boost your stock trading profits. Investors often resort to buying on margin in a bullish stock market when they are sure that their liability will be easily paid off, once the price of the security rises.
When they make a profit, they pay back the loan amount and land up with a bigger profit margin, as their own principal investment is marginally lesser. An advantage of buying on margin is the way in which it substantially increases your buying power. It's stock investing using leverage.
To start margin trading, an investor is required to open a separate margin account with the stock broker. The requirements of this account are different from a normal cash account. There is a certain minimum amount that you need to pay before you can start trading through your margin account. Also, you need to maintain a minimum balance decided by the broker if you want to continue using this account.
As a general rule, you can borrow funds that are 50% of the price of stock that you are planning to buy. Interest is charged on the borrowed amount until you repay the loan. When you make a successful sale and gain profits, the broker takes his share out of it until you have fully repaid your loan. Also the securities you buy are used as collateral for your loan.
Debt to Equity Ratio
The equity value is the value of your holding stock according to current market price. If it so happens that the value of your equity falls, you need to deposit cash or other securities in your margin account to maintain the debt to equity ratio.
There is an important regulatory measure that you need to know if you are considering buying securities on margin. As a general rule, the investor needs to see to it that the borrowed loan or debt to personal equity value ratio in the margin account, is maintained to be 50% or lesser. That means, if I hold an equity of $30,000 worth, then I can only borrow a loan up to or less than $15,000.
Borrowed sum, as a leverage, can be used to maximize the profit, but, if the invested stock fails to perform you may land up with heavy debt. In case of a dip in debt to equity ratio, you might get a call from the broker to pay up, which is called a 'margin call' in stock terms. Though risk is inherent in stock trading, it is higher when you are buying on margin. It is not a recommended course of action in beginner investing.
Which Stocks Cannot be Bought on Margin?
Not all stocks can be bought using a margin account. The stock exchange regulatory board doesn't let you buy securities like Initial Public Offerings (IPOs), penny stocks and over the counter bulletin board securities on margin. This is a measure enforced by the regulatory commission to reduce day-to-day trading risks. Other than that, a broker may decide to restrict your stock choice. When opening a margin account, read all the terms and conditions carefully and note the interest rates charged on your loans which you are going to buy stocks.
It is risky business as you may end up in serious debt if your stock does not perform as well as expected. Only experienced and seasoned investors, who have enough ballast to steady their ship in case of hitting rough waters, can go for such a margin trade. I feel that it's always a better strategy to bet out of your own pocket. This strategy will stand you in good stead in the long run.
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