What is Foolsaurus?

It's a glossary of investing terms edited and maintained by our analysts, writers and YOU, our Foolish community. Get Started Now!


The Rate of Return of Buying Stock on Margin

Original post by Slav Fedorov of Demand Media

Margin is the amount of money or other securities an investor must put up when buying stocks with money borrowed from a broker. If a brokerage account is approved for margin, the use of margin is automatic, up to the maximum legally allowable limit. Buying on margin means buying a stock partially with funds borrowed from a broker.

Contents

How It Works

For most stocks, the initial margin is 50 percent, which means that an investor can buy 500 shares of XYZ stock at $20 per share for a total of $10,000 by putting up $5,000 of his own money and borrowing the other $5,000 from his broker. By law, an investor must maintain a minimum margin balance in his account. The minimum margin varies from broker to broker but cannot go below 25 percent. For example: If the value of XYZ declines to $7,500, the investor would still owe $5,000 to the broker, so the investor's equity would shrink to $2,500, or 33.3 percent of the then current value of the stock.

Effect of Margin

Margin can magnify both gains and losses because an investor's return is based on his own funds, not the total value of a holding.

Margin Return Calculations

The rate of return of buying stock on margin depends on the amount of the original margin an investor puts up when buying a stock. For example: XYZ appreciates 50 percent to $30. Investor A, who bought XYZ with cash, would have a 50 percent gain; investor B, who bought XYZ on a 50 percent margin, would have a 100 percent gain (the $10,000 initial investment grows to $15,000 as XYZ advances from $20 to $30; investor B still owes the broker $5,000, so his own stake has grown from $5,000 to $10,000); investor C, who bought with a 75 percent margin, would have a 66.7 percent return (the $10,000 initial investment grows to $15,000 as XYZ advances from $20 to $30, but since investor C put up $7,500 of his own money and borrowed $2,500; his stake is now worth $12,500). Essentially, the use of the maximum 50 percent initial margin can double whatever return can be achieved in a stock on a cash basis. The larger the initial margin, the less it magnifies the gain.

Margin Risk

Since a 50 percent margin can double an investor's cash stock return, it can also double his losses if the stock declines. If XYZ drops to $10 from $20, investor B's 50 percent stake would be completely wiped out (500 shares times $10 per share = $5,000, minus the $5,000 margin loan = 0). Before that happens, however, investor B would get a margin call from his broker as soon as his equity drops below the minimum allowable margin of 25 percent. A margin call is a demand to deposit more cash or other securities to bring the margin back to the limit. If investor B does not comply, the broker will sell XYZ at market to cover its $5,000 margin loan.


                   

Resources

References

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.


Advertisement