Borrowing from your broker to buy a security (stock, bond or futures contract) is referred to as buying on margin.
You use the security or other securities in your portfolio as collateral.
When you borrow to buy on margin, you pay margin interest rates set by the broker. This is usually a fairly high rate, though not as high as a credit card.
Why do investors buy on margin?
Margin buyers are trying to buy larger positions than they can afford out of pocket in order to get more exposure - leverage - from their investments.
To buy on margin, you must set up a margin account with your broker.
This involves depositing a certain amount and signing several forms indicating you understand the terms and conditions.
This can be done online with online brokers.
Not all securities are marginable. Some low-price or risky stocks do not qualify for margin buying.
Buying on Margin
When you buy a security on margin, you must have enough collateral to make the purchase.
A margin requirement of 50% for stocks is required in the US, set by the Federal Reserve.
That means you must have at least 50% of the entire purchase available in your account as cash or equity. This is to prohibit you from borrowing too much.
This 50% requirement only applies to the initial purchase. After that, rules set by your broker apply.
There is a minimum maintainance requirement below which your equity portion will trigger a sale or a request for more equity (cash) to be whole. This is a margin call.
A typical minimum maintainance requirement is 35%, meaning that once your equity falls below 35% of the entire stock position, you get the call.
For example, if you buy 1000 shares of a $1 stock for $1000, you can borrow $500 of the $1000. If the stock drops below the point where the equity portion of the investment is 35%, you will trigger the call.
What is that price when you get a margin call?
The formula is: Borrowed Amount / (1 - Maintainance Requirement).
If the maintainance requirement is 0.35 and you borrowed $500, the formula would give you the total securities value to match 35%, in this case $500/(0.65), or $769.23.
That means that if your $1 stock goes down to 76.9 sen, you will get a margin call.
Margin positions are evaluated each night for sufficient equity.
The calculation of margin sufficiency is more complex with multiple securities in an account.
The above example applies to stocks; the initial and maintainance margin requirements are differnt for commodities.
What you should know about buying on margin?
Margin can add power to your investment portfolio.
Like any other borrowings, it can be DANGEROUS, and should be treated accordingly.
Margin interest rates, while moderately high, can be lower than some other forms of short-term borrowing, so it might make sense to use margin to get some cash from your investment account for certain purposes.
On a larger scale, when stock margin borrowing levels increase in aggregate, it is a sign that too many people are speculating on stocks and that a bubble might be forming, leading to a bust later on.
101 Economics by Peter Sanders