Short sellers of stock use margin to trade shares. The Federal Reserve Board sets the margins securities.
As with any loan, when an investor buys securities on margin, they must eventually pay back the money borrowed, plus interest , which varies by brokerage firm on a given loan amount. Monthly interest on the principal is charged to an investor's brokerage account. Essentially, buying on margin implies that an individual is investing with borrowed money. Although there are benefits, the practice is thus risky for the investor with limited funds. To see how buying on margin works, we are going to simplify the process by taking out the monthly interest costs.
Although interest does impact returns and losses, it is not as significant as the margin principal itself. The broker sets the minimum or initial margin and the maintenance margin that must exist in the account before the investor can begin buying on margin.
The amount is based largely on the investor's creditworthiness. A maintenance margin is required of the broker, which is a minimum balance that must be retained in the investor's brokerage account.
At this point, the investor is required by the broker to deposit funds to bring the balance in the account to the required maintenance margin. The investor can deposit cash or sell securities purchased with borrowed money. If the investor does not comply, the broker may sell off the investments held by the investor to restore the maintenance margin.
Generally speaking, buying on margin is not for beginners. It requires a certain amount of risk tolerance and any trade using margin needs to be closely monitored. Seeing a stock portfolio lose and gain value over time is often stressful enough for people without the added leverage. Furthermore, the high potential for loss during a stock market crash makes buying on margin particularly risky for even the most experienced investors.
However, some types of trading, such as commodity futures trading, are almost always purchased using margin while other securities, such as options contracts , have traditionally been purchased using all cash. Buyers of options can now buy equity options and equity index options on margin, provided the option has more than nine 9 months until expiration. For most individual investors primarily focused on stocks and bonds, buying on margin introduces an unnecessary level of risk.
Risk Management. Portfolio Management. Trading Instruments. With the country in an exuberant mood, the stock market seemed an infallible investment in the future. As more people invested in the stock market, stock prices began to rise. This was first noticeable in Stock prices then bobbed up and down throughout and , followed by a "bull market," a strong upward trend, in The strong bull market enticed even more people to invest.
By , a stock market boom had begun. The stock market boom changed the way investors viewed the stock market. No longer was the stock market only for long-term investment. Rather, in , the stock market had become a place where everyday people truly believed that they could become rich. Interest in the stock market reached a fevered pitch. Stocks had become the talk of every town.
Discussions about stocks could be heard everywhere, from parties to barbershops. As newspapers reported stories of ordinary people, like chauffeurs, maids, and teachers, making millions off the stock market, the fervor to buy stocks grew exponentially. An increasing number of people wanted to buy stocks, but not everyone had the money to do so. When someone did not have the money to pay the full price of stocks, they could buy stocks "on margin.
Buying on margin could be very risky. If the price of stock fell lower than the loan amount, the broker would likely issue a "margin call," which means the buyer must come up with the cash to pay back his loan immediately.
In the s, many speculators people who hoped to make a lot of money on the stock market bought stocks on margin. Confident in what seemed a never-ending rise in prices, many of these speculators neglected to seriously consider the risk they were taking.
By early , people across the United States were scrambling to get into the stock market. The profits seemed so assured that even many companies placed money in the stock market. Even more problematic, some banks placed customers' money in the stock market without their knowledge. With the stock market prices upward bound, everything seemed wonderful.
When the great crash hit in October, people were taken by surprise. However, there had been warning signs. On March 25, , the stock market suffered a mini-crash. It was a prelude of what was to come. As prices began to drop, panic struck across the country as margin calls—demands by the lenders to increase the borrower's cash input—were issued.
When banker Charles Mitchell made an announcement that his New York-based National City Bank the largest security-issuing entity in the world at the time would keep lending, his reassurance stopped the panic.
Although Mitchell and others tried the tactic of reassurance again in October, it did not stop the big crash. By the spring of , there were additional signs that the economy might be headed for a serious setback. Steel production went down; house construction slowed, and car sales waned. At this time, there were also a few reputable people warning of an impending, major crash.
However, when months went by without one, those that advised caution were labeled pessimists and widely ignored. Both the mini-crash and the naysayers were nearly forgotten when the market surged ahead during the summer of From June through August, stock market prices reached their highest levels to date. To many, the continual increase in stocks seemed inevitable.
When economist Irving Fisher stated, "Stock prices have reached what looks like a permanently high plateau," he was stating what many speculators wanted to believe.
On Sept. Two days later, the market started dropping. At first, there was no massive drop. Stock prices fluctuated throughout September and into October until the massive drop on Black Thursday. On the morning of Thursday, Oct. Black Tuesday is often cited as the beginning of the Great Depression. When was the stock market at its highest? What was the impact of buying on credit s? The prosperity of the s led to new patterns of consumption, or purchasing consumer goods like radios, cars, vacuums, beauty products or clothing.
The expansion of credit in the s allowed for the sale of more consumer goods and put automobiles within reach of average Americans. Why is buying on margin dangerous? But the strategy is extremely risky. Buying on margin involves getting a loan from your brokerage and using the money from the loan to invest in more securities than you can buy with your available cash.
Investors can potentially lose money faster with margin loans than when investing with cash. How did the stock market crash trigger a chain of events that led to the Depression? The stock market crash of was not the sole cause of the Great Depression, but it did act to accelerate the global economic collapse of which it was also a symptom. By , nearly half of America's banks had failed, and unemployment was approaching 15 million people, or 30 percent of the workforce.
Will the market crash in ? Yet, volatility is just one reason the world's biggest hedge fund managers and leading economists are predicting a crash. Another reason is rising interest rates. Is Margin Trading a good idea? It's a good idea to view margin trading as a short-term strategy, one where you use your margin account sparingly and only to try to reap short-term market gains.
Is Margin Lending a good idea? Margin lending can be a high risk, high return investment strategy. It's a great way to squeeze the investment value out of your capital, but the unwise - or unlucky - investor can lose money just as quickly.
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