Buying on margin lets investors increase potential return with borrowed money, but it’s a big risk. The Federal Reserve Board’s Regulation T, or Reg T, limits that risk. The collection of rules limits how customers can trade using cash accounts. It is also used whenever an investor buys on margin, using money borrowed from a broker and shares as collateral.Buying on Margin
Buying on margin lets investors increase their purchasing power. By borrowing to buy stock, they can own many more shares than they could if restricted to buying only what they could pay for in cash.
Margin investing can produce much higher returns. For example, if an investor buys 100 shares of stock at $10 and pays cash, it will cost $1,000. If the share price doubles to $20, the shares are worth $2,000 and the investor can sell them and pocket $1,000. That’s a 100% return.
If the same investor borrows another $1,000, he or she can buy 200 shares at $10. Then if the price doubles to $20 the investor has shares worth $4,000. After selling them and paying back the $1,000 margin loan, the investor has $3,000. That’s a 300 percent return on the original $1,000 in cash.
In reality, the investor will also have to pay interest on the loan from the broker. But margin investing can still greatly increase returns by leveraging credit.Margin Risks
Margin buying can have a steep downside if the price of shares bought with borrowed money declines. Should that happen, investors will be exposed to much greater losses than when paying in cash.
For instance, say 200 shares bought for $10 each with $1,000 in cash and $1,000 in credit decline 50 percent to $5. They will now be worth just $1,000.
If the investor sells them, he or she will have nothing left after paying back the $1,000 borrowed for the purchase. That is a 100% loss on a 50% decline in price.
After interest, the investor will be out more than the initial investment. And if the share price fell further, the investor could lose far more.
For instance, a 60% price drop to $4 in the previous example would mean the investor’s 200 shares are worth just $800. After paying back the $1,000 margin loan, the investor would be out $200 more than he or she started with.
Protecting investors from these risks of margin investing is the purpose of Reg T.Reg T Provisions
Reg T permits margin investors to borrow no more than 50% of the price of shares on a margin purchase. That is, for the margin example above the investor could not borrow more than $1,000 toward the $2,000 purchase. This is intended to limit the potential for losses.
Reg T also compels investors to open a margin account with their brokerage before investing on margin. Interest rates and terms of these margin accounts can vary depending on the brokerage.Other Reg T Provisions
Reg T also has rules about cash accounts, where the investor pays in full for purchased stock. Because it can take two days to settle a trade, an investor with a cash account could buy a stock and then sell it before the trade settles.
This practice is called freeriding and one provision of Reg T prohibits it. If an investor tries it, the account could be frozen by the broker for 90 days.Other Margin Rules
Reg T is just one of the rules on margins investors may encounter. For instance, the Financial Industry Regulatory Authority (FINRA) requires investors to deposit a minimum margin of $2,000 or 100% of the purchase price if it’s less than $2,000 before conduction a margin trade.
FINRA also has a maintenance requirement. This forces investors to maintain equity in their accounts equal to at least 25% of the total market value of the securities in their margin account. Equity equals the value of the securities in the account minus whatever the investor has borrowed from the brokerage.
The New York Stock Exchange, the National Association of Securities Dealers and individual brokerages also have their own rules. For instance, a brokerage may limit investors to less than the Reg T 50% maximum credit. It may also require investors to meet higher maintenance requirements.
Investors who find themselves short of a margin requirement may get a margin call from their brokers alerting them to the need to deposit more cash or securities. If the investor doesn’t fund the margin account adequately, the brokerage may sell shares to bring the account up to the required level. Margin calls can produce large losses for investors forced to sell at the bottom.History of Reg T
Reg T allows the Federal Reserve Board of Governors to change the margin requirements. Over the decades the amount of cash needed for a margin trade has ranged from 40% to 100%.
However, in recent years the Fed has been reluctant to change this requirement. The current 50% margin requirement has been in place since 1974.Bottom Line
Regulation T limits the just how much an investor can borrow from their broker to purchase securities on margin. By setting a limit of 50% borrowed funds, the Federal Reserve minimized the amount of trouble investors can get into if there’s a margin call.
Investors are also prohibited buys and sells the same securities before paying for them from thier cash account, or freeriding. If any of those restrictions present a problem for you and your investments, you may want to consult a financial advisor and consider another way forward.Investment Tips
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