How to Use Margin
Margin is borrowing money from your brokerage house for the purpose of purchasing additional stock. How much money you can borrow depends upon how much marginable equity you have in the account. Once you purchase stock using your margin, the amount you owe is fixed and accrues interest. As long as the accumulated debt plus interest remains under the margin requirements, you do not have to "pay off" the loan. Of course, interest continues to accrue until the margin debt is paid back, usually by selling the stock that was purchased.
Margin Requirements
The Federal Reserve sets minimum margin rules that must be followed by all brokers. Currently these rules are:
- 50% Margin on new positions
- 25% Margin on "maintenance" positions
For example, for a new position, if you purchase $10,000 of marginable stock, you can purchase an additional $10,000 of marginable stock.
For instance, if you purchase 1,000 shares of a $10 stock, using $10,000 cash in your account, an additional 1,000 shares can also be purchased on margin. Your margin debt is now $10,000, on which interest begins to accrue immediately.
This is a 50% margin because you owe $10,000 with $20,000 worth of stock in the account. If the price of the stock falls to $6.75, however, you'll now owe $10,000 on stock that is only worth $13,500. Your remaining equity in the position would be $3,500 ($10,000-$6,500). This is a ratio of 26% equity, which is slightly more than the margin maintenance limit. If the stock price falls below this level, your broker may ask you to reduce your margin debt and/or may liquidate the position.
Marginable Stock
Not all stock is marginable. Some stocks cannot be used as collateral for borrowing margin debt.
Brokerages are permitted to set any additional rules which could be more restrictive than the Federal Reserve requirements. Most brokerages have done this for many stocks, particularly those that experience high price volatility. These rules may vary by brokerage.
Marginable Stocks Can Be Shorted
When you hold stock in a margin account, the brokerage agreement gives the brokerage house the ability to lend your stocks to other account holders who want to sell your stock short. Stock held in a cash account generally cannot be lent to short sellers. If you don't want short sellers to be able to borrow your stock, hold it in a cash account. Of course, this also means you won't be able to borrow against it.
Calculating Your Margin Capability
Before purchasing stocks on margin, it's always wise to check what your margin capability is. This is especially true when you mix marginable stock and nonmarginable stock along with margin debt.
In general, the following principles apply:
- Only your marginable stocks count towards your margin capability.
- Nonmarginable stocks can be bought using margin, but the margin capability is drawn against marginable stocks, and the new nonmarginable stock comes without any additional margin capability.
For example, if you have $10,000 worth of marginable stock in your account (which is still the one opened $10,000 in cash), you can purchase one of the following:
- $10,000 worth of additional marginable stock, or
- $5,000 worth of nonmarginable stock
When you purchase nonmarginable stock using the margin capability of the marginable stock, any change in price of your nonmarginable stock will have no effect on your margin capability. If the nonmarginable stock doubles in price, but the marginable stock declines, you may still face a margin maintenance call.
Briefing.com Thoughts
Margin should be used with great caution. Many people blame the collapse of the stock market in 1929 on the low margin requirements of only 10%. While the 50% and 25% margin requirements help keep the market orderly, they do nothing at all for limiting your personal loss. If you use your entire 50% margin to establish a new position, and the stock falls, you still owe the money. If you are unable to add money, you risk having to sell your stock to close the margin position. Margin increases your personal risk, and you should fully understand the nature of that risk before purchasing stock using your margin capability.
