how margin debt works
as an example of using margin debt to buy securities suppose an investor who we ll call sheila wants to buy 1 000 shares of johnson johnson jnj for 100 per share she doesn t want to put down the entire 100 000 at this time but the federal reserve board s regulation t limits her broker to lending her 50 of the initial investment also called the initial margin 1she deposits 50 000 in initial margin while taking on 50 000 in margin debt the 1 000 shares of johnson johnson that she then purchases act as collateral for this loan not all brokers would allow sheila to borrow that much brokerages often have their own rules for buying on margin which can be stricter than those imposed by regulators excessive buying on margin is considered one of the causes of the famous u s stock market crash in 1929 at that time margin rules were much looser often allowing investors to borrow 90 of the money to buy stocks and putting down only 10 in cash we know today how that turned out 2advantages and disadvantages of margin debtbuying on margin has both risks and potential benefits for investors generally speaking it isn t for beginners or for those who can t afford to lose money two scenarios illustrate the potential risks and rewards of taking on margin debt in the first johnson johnson s price drops to 60 sheila s margin debt remains at 50 000 but her equity has fallen to 10 000 which is the value of the stock 1 000 60 60 000 minus her margin debt of 50 000 the financial industry regulation authority finra and the exchanges have a maintenance margin requirement of 25 meaning that customers equity must remain above that ratio in margin accounts 1falling below the maintenance margin requirement triggers a margin call unless sheila deposits another 5 000 in cash to bring her margin up to 25 of the securities 60 000 value or 15 000 the broker is entitled to sell her stock without notifying her until her account complies with the rules this is known as a margin call here again brokerages may have stricter rules than the law requires such as setting their maintenance margin requirement at 30 or 40 for example 3allows investor to buy stock with borrowed moneyinvesting on margin can magnify any gains because of leverage resulting in greater profitbuying on margin means taking on debt that must be repaidif stock loses value investor may face a margin call and have to come up with cash quicklya second scenario demonstrates the potential rewards of trading on margin say that in the example above johnson johnson s share price rises to 150 sheila s 1 000 shares are now worth 150 000 with 50 000 of that being margin debt and 100 000 equity if sheila sells commission and fee free she receives 100 000 after repaying her broker her return on investment roi is equal to 100 a 50 000 return on her 50 000 cash investment now let s assume that sheila had purchased the stock simply using a cash account meaning that she funded the entire initial investment of 100 000 so she does not need to repay her broker after selling her roi in this scenario is equal to 50 a 50 000 profit on her cash investment of 100 000 in both cases her profit was 50 000 but in the margin account scenario she made that money using half as much of her own capital as in the cash account scenario the capital she has freed up by trading on margin can now go toward other investments if she wishes these scenarios illustrate the basic tradeoff involved in taking on leverage the potential gains are greater but so are the risks 