Buying stocks on margin can sound like a perfect way to make money. You can qualify to borrow money at a low interest-rate against your existing stocks if you have a few thousand dollars in your stock trading account. You can utilize the borrowed cash to purchase even more shares. In theory, this will potentially leverage the returns.
In reality, buying on margin is an extremely risky strategy that can turn even the safest large-cap share purchase into a high-stakes bet. It helps aggressive traders to buy more stocks than they could otherwise afford. These investors earn a lot of money when things go according to the plan. It can get really unpleasant when things go south quickly. What happened to margin buyers during the crash?
What does it mean to buy on margin?
Margin buying involves borrowing funds from a broker to buy stock. You can consider it as a loan from your stockbroker. Buying on margin allows you to purchase more shares than you would normally able to afford. Usually, your stockbroker lends money to you at comparatively low rates, which gives you more purchasing power for stocks than your cash alone would have provided. Your account, including any assets held within it, serves as collateral for the loan. The broker won’t share any of the investment risks with you.
The margins are determined by the Federal Reserve Board. As of 2019, the board needs an investor to finance at least 50 percent of a security’s purchase price with cash. The investor can borrow the remaining 50 percent from a dealer or broker.
Did buying on margin contribute to the crash?
Yes, buying on margin contributed to the stock market crash. A person who is buying on margin hopes that the share price rises so that they can pay off the loan. As the number of people buying shares with borrowed money increased, the demand for stocks increased.
People were willing to pay inflated prices for the stocks that they were buying on margin. They were overconfident about the prospects. As a result, the stock prices surged more than they should have. The bubble finally burst and stock prices plummeted. When the stock prices fell, all of the people who had bought shares on margin were in trouble. They couldn’t repay their loans since the share prices hadn't risen. The investors who had bought on margin were forced to sell their stock, which set off more of a decline.
What happened to margin buyers during the crash?
When the stock market crashed and brokers made their margin calls, investors who had bought on margin weren't able to meet the maintenance requirements or repay their loans. For example, you buy $20,000 worth of stocks by paying $10,000 yourself and borrowing $10,000 from your broker. If the market value of the stocks falls to $15,000, the equity in your account drops to $5,000.
Assuming a 25 percent maintenance requirement, you must have $3,750 in equity in your account. As a result, you are fine in this case since your equity of $5,000 is higher than the required maintenance margin of $3,750.
However, let's say your broker's maintenance requirement is 40 percent instead of 25 percent. In this situation, the $5,000 worth of equity in your account is lower than the required maintenance margin of $6,000. As a result, the broker may issue you a margin call.
Can investors lose all of their money when the stock market crashes?
Yes, investors can lose all of their money when the stock market crashes. When you buy stock on margin, you can lose more money than you invested. For example, when a stock price falls by 50 percent or more, you can lose more than 100 percent with commissions and interest on top of that.