The Basics
Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account in which you trade using the money in the account. By law, your broker is required to obtain your signature to open a margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement.
Any purchase of securities on margin requires providing a deposit equal to part of the purchase price. There is no need to ask for an advance in purchasing shares. The investor merely has to deposit the sum required to cover the margin requirement. The investor may then decide whether to buy on margin, in whole or in part, or whether to pay the total purchase cost. It should be noted, however, that the margin can be used only if there is liquidity in the account.
The amount of margin, or loan, provided for share purchases is determined by the specific loan value of each stock. While some stocks may not provide the right to any loan value, others may be eligible for loans of up to 70% of market value.
In Canada and the United States, shares trading above $3.00 are generally eligible for a loan value of 50% of market value. In general, most shares trading above $5.00 and that qualify for options are eligible for a loan value of - 70%.
Some stocks fail to meet eligibility criteria and provide no right to credit or loan value. This applies in particular to any shares trading at less than $3.00 and to all shares listed on the CDNX in Canada or on the Pink Sheetor OTC BB marketsin the United States.
You can keep your loan as long as you want, provided you fulfill your obligations. First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan, until it is fully paid. Second, the overall net margin of your account must remain positive otherwise your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it's known as a "margin call." We'll talk about this in detail in the next section.
Marginable securities in the account are collateral. Borrowing money isn't without its costs - you'll also have to pay the interest on your loan. Interest is calculated on a daily basis and posted to your account each month.
The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on.
Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater a return you need to break even.
A Buying Power Example
Let's say you deposit $10,000 in your margin account. Because you put up 50% of the purchase price (for a stock trading above $3 but is not option eligible), this means you have $20,000 worth of buying power. Then, if you buy $5,000 worth of this stock, you still have $15,000 in buying power remaining. You have enough cash to cover this transaction and thus haven't tapped into your margin. You start borrowing the money only when you buy securities worth over $10,000.
This brings us to an important point: the buying power of a margin account changes daily depending on the price movement of the marginable securities in the account. Later in the tutorial, we'll go over what happens when securities rise or fall.
