Definition: Buying on margin is an operation where a buyer borrows certain amount of money from his broker to complete a investment transaction. It is a loan extended by the broker to finance the operation.
What Does Buying on Margin Mean?
In order to buy on margin a person must hold a margin account with his broker. These accounts have different conditions and operational characteristics than regular accounts. When a person buys certain security on margin it means that the broker finances a part of the transaction. The account holder places a down payment, which means a portion of the total amount invested and the broker pays for the rest. The securities being bought are held as collateral for the loan and there are elements like maintenance margins, minimum margins, interest expenses and operational expenses that are also charged to the holder to sustain the margin account.
As any other loan, the financial institution will assess the person’s or institution’s creditworthiness before the margin account is actually approved. Also, there are certain procedures such as “margin calls” that can be employed if the margin account balance is reduced by adverse results. These calls are measures that allow the broker to liquidate investment positions in order to maintain the minimum equity portion required for the margin account.
Let’s say Mr. Lambert has a margin account with an initial investment of $20,000 coming from his savings. He decided to design his own investment portfolio and he is enthusiastic about its potential. In order to increase the portfolio results he took a $10,000 margin, which means his current portfolio is worth $30,000.
He went on and bought many different stocks, bonds and ETFs and according to his margin account agreement the maintenance margin is 25%, he has to pay an annual interest rate of 2% on the loan and there’s a 0.025% operational expense calculated on its margin balance at the end of each month. The securities he purchased serve as collateral for the loan. Mr. Lambert is confident about his portfolio and that’s the reason why he wanted to boost its results through a margin operation.