Buying on margin

14 January 2019 by National Bank
Buying on margin

Buying on margin is a strategy used by many investors. It allows you to borrow money from National Bank Direct Brokerage (NBDB) to pay for part of your investments. By buying on margin, you’ll benefit from more cash and be able to buy more stocks than you’d normally be able to. This allows you to take advantage of good opportunities and maximise returns thanks to something called leveraging. In any case, it’s important to understand how a margin account works and how it differs from a cash account. 

Margin Account vs. Cash Account

With a cash account, you can only use the money in your account to buy stocks. You either pay with your cash, or you don’t buy at all.

Things work differently with a margin account: if you don’t have the necessary funds to buy stocks or invest, you can borrow money to buy more stocks than you can pay for yourself.

Comparing the purchasing power of a cash account and a margin account

Let’s say that your account currently contains:

  • 200 shares of XYZ worth $40 each
  • 100 shares of ABC worth $6 each
  • A cash amount of $5,000

Scenario #1: Cash account

You have $5,000 of purchasing power available to you.

Scenario #2: Margin account

Say you have the same stocks and cash amount, only now they’re in a margin account.

Shares valued at more than $5 generally allow a 70% advance from the broker (margin rate). Your available purchasing power would then be equal to $11,020. 

This total is calculated by adding the value of your available loans to your cash amount:
$5,600 ($8,000 x 70%) + $420 ($600 x 70%) + $5,000 (cash amount) = $11,020

Summary table for scenarios #1 and #2

  Symbol Quantity Average cost per unit Market value Available loan value Cash amount Available purchasing
power
Cash account XYZ 200 $40 $8,000 $0 $5,000 $5,000
ABC 100 $6 $600  
Margin account XYZ 200 $40 $8,000 $5,600 $5,000 $9,270
ABC 100 $6 $600 $420

 

The purchasing power for a margin account is greater than for a cash account, but it’s still important to properly understand how margin accounts work to fully grasp the pros and cons. In fact, they are subject to certain regulations that you should be aware of.

Buying on margin, step by step

1.    To be able to buy on margin, you must first open a margin account. This will allow you to borrow part of the market value of the stocks in your account. The maximum amount you can borrow depends on the type of investment and the stock’s market value.

  1. You must then make a deposit into the account. This amount is referred to as the margin requirement and will act as a partial settlement of the transaction. The sum of this requirement and the loan (the broker’s advance) corresponds to the total cost of the operation.
  2. The loan amount depends on the price of the stocks you want to buy. NBDB can lend you up to 70% of the amount you want to invest. Please see further below in this article for a summary of these amounts.
  3. Interest rates on the loan will be applied to your account. Daily interest on the loan is calculated based on the margin account’s debit balance every month.
  4. If the price of the stocks you purchased falls below a certain level, your account will be in margin call. If this occurs, you must immediately make a deposit into your account or proceed with closing sales.
  5. Security deposit: Buying any stock on margin requires a security deposit equal to a portion of the purchase price paid for by the investor. This is used as a loan guarantee and can be sold at any time by NBDB.

Following fluctuations with the trading platform

As an investor, you must abide by the purchasing power generated by the price fluctuation of your stocks, because it isn’t fixed in a margin account – it changes according to the values of the stocks in the account. To do this, just use the trading platform regularly to follow the market fluctuations.

How do you know how much to borrow?

The Investment Industry Regulatory Organization of Canada (IIROC) determines the minimum standards based on the share price. However, in some cases NBDB can impose more rigourous requirements in order to protect their clients. Here are some examples of NBDB’s maximum funding advance:

Stock categories NBDC’s maximum
advance (Funding in % of the market value)
Shares worth $5 or more 70%
Shares from $2 to $4.99 50%
Shares worth less than $2 No advance possible
Canadian mutual funds, in CDN or USD 50% (except money market)

 

 

Example of buying with a margin account

An investor wants to buy 1,000 shares for $10.00 each, believing that the share price will increase. The transaction will therefore require a $10,000 investment. 

Since this stock is eligible for reduced requirement, NBDB can provide a loan of up to 70% of the total cost – meaning $7,000 – and the investor only has to pay $3,000.

Scenario 1: The share price increases to $14.00

Say the share price increases to $14.00. If the investor sells their stocks, they will have made $4,000.

Given that the investor only paid $3,000 originally, this represents a 133% growth, excluding interest. If the investor had paid the entire $10,000, there would have only been a 40% growth on the initial investment.

Scenario 2: The share price falls to $8.00

Leverage also has an impact in cases where the share price falls, meaning losses will also be greater than if a cash account had been used. 

Say the share price is down to $8.00. If the investor sells their stocks, they will have lost $2,000.

Given that they only spent $3,000 on the investment, this represents a 67% loss, excluding interest. If the investor had paid the entire $10,000, there would have only been a 20% loss on the initial investment.

The three main advantages of buying on margin

  • Cash available right away
  • Low interest rate
  • No minimum monthly payment required – as long as the stocks in the account generate purchasing power, only interest on the “loan” balance will be accrued

As you can see, buying on margin leverages your returns both positively and negatively. Before trying it out, check if it aligns with your goals for your portfolio and, above all, make sure you understand how it works. Also, take the time to carefully go over your margin account agreement before making any investments, so you’re informed on how to calculate interest and on your responsibilities regarding advance reimbursements and loan security.

___

*In some cases, National Bank Direct Brokerage can demand higher requirements than indicated in the table. If the price of the share bought on margin falls, this reduces the broker’s advance and the investor will have to pay a supplementary requirement.

**Stocks eligible for reduced requirement only. High cash and low volatility criteria are some of the aspects used to determine which stocks are eligible for reduced requirement. 

 

Notes légales 

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