Margin buying is a process in which securities are bought with the help of one’s own money in addition to money taken as a loan from a broker. This results in the amplification of any loss or gain on the securities. The securities that have been purchased are utilized in the form of pledge or security for the loan.
The variation between the loan and the value of the securities, which is termed as the net value remains the same as the individual’s own amount of money utilized in the beginning. It is necessary that this variation remains more than the minimum margin requirement. The goal or objective behind this is to provide protection or safeguard to the broker from a downfall in the securities value to the level that they do not have the capacity to cover the loan.
The margin requirements were flexible in the 1920s. Put differently, the investors only deposited small or minor amount of their own money to the brokers.
When there was a sharp decline in the stock markets, the net value of the margin buying positions got lower than the minimum margin requirements at a rapid pace and this impelled the investors in selling out their positions. This is regarded as a substantial element, which led to the Stock Market Crash of 1929, and this sequentially resulted in the Great Depression.
The concept of margin buying can be better explained with the help of an example. If an investor purchases a share of a reputed company for US$ 100, in which he utilized US$ 80 as a loan taken from the broker and US$ 20 as his own fund, then the net value becomes US$ 20 (share minus loan).
If the broker is asking for a minimum margin requirement of US$ 10 and the value of the share has gone down to US$ 85, the net value becomes US$ 5. In this situation, the investor has two options. He can sell the share or make a repayment of a portion of the loan such that the position’s net value goes up more than US$ 10.
Last Updated on : 1st July 2013