How Investors Buy on Margin
Buying on Margin, also known as Margin Buying, is the practice of buying shares or securities using money borrowed from a broker. The amount of the loan may be several times more than the investor’s own contribution- for example $20 from the investor and $80 from the broker to purchase a $100 share of stock. Since the purchased securities themselves are the collateral backing up the loan, buying on margin can be a risky business indeed!
What margin buying does is to inflate any profit made on a rise in share values - and on the downside, exaggerate any loss should the share price fall. The brokers who make the loans to investors protect themselves by requiring that the “net value” of the purchased securities, which is originally the same as the cash used by the investor, stay above a set minimum margin requirement. Should the net value fall below the minimum margin requirement, the broker will issue a Margin Call and the investor must then either invest additional funds or close out his/her position by selling the securities. Buying on margin is not only practiced with stocks, but also options and futures.
Margin requirements today are stringently controlled, but such was not always the case. During the Roaring Twenties, it was felt that the rising stock market was a self-perpetuating phenomenon and both investors and brokers were eager to ride the wave ever higher. Hopes were dashed and fortunes crumbled, however, in October of 1929 when a series of sharp drops in share values forced investors to sell their equities in order to meet their margin commitments. Bargain hunters could not reverse the flood of sell orders and the result was the Stock Market Crash of 1929, one of the most devastating stock market crashes in history.
While buying on margin itself was not the only cause of the 1929 crash, it was recognized as a significant factor contributing to its severity, and securities reform legislation in the 1930s was intended to tighten the regulations concerning margin lending. More recent market crashes, such as those in 1987 and 1997 were deemed to have been exacerbated by program trading and an Asian stock market correction, respectively.
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