DEFINITION: The term “margin,” when used in the realm of finance, refers to the collateral that investors must place with their broker or exchange.
The purpose of this collateral is to mitigate the potential credit risk to the broker or exchange that might be created by an investor’s actions.
Investors can create credit risk for brokers and exchanges when they borrow financial instruments for the purpose of short selling, when they borrow funds from the broker to acquire financial instruments, or when they deal in derivative contracts.
Margin-buying takes place under the following circumstances. First, an investor borrows money from his broker for the purpose of purchasing an asset. Second, the broker counts the collateral that the investor has already deposited with him as collateral for the new loan. This second step is what makes the loan “on margin.”
ETYMOLOGY: The term “margin,” when used in the financial context, is short for “margin of safety.” It was introduced to the financial literature in 1934 by Benjamin Graham and David L. Dodd in the first edition of their classic textbook, Security Analysis.
The English word “margin” is attested from the fourteenth century. It derives from Middle English and, ultimately, from the Latin noun margo, marginis, meaning “edge” or “border.”
USAGE: The concept of “margin” relates to the level of ownership that investors maintain within their brokerage account.
The concept of “buying on margin” means using funds borrowed from a broker to acquire securities.
Thus, buying on margin presupposes owning a margin account, which is distinct from a regular brokerage account.
A “margin account” denotes a brokerage arrangement in which the broker extends a loan to the investor, enabling the latter to acquire a greater volume of securities than the investor’s regular brokerage account balance would allow.
The term “margin” may be used in a variety of different contexts, apart from finance.
For instance, margin may be said to represent the difference between the selling price of a product or service and its production cost.
Another way of looking at margin is as a representation of the proportion of a company’s profit in relation to its revenue.
Finally, the concept of margin may also be used to describe the segment of interest rate within an adjustable-rate mortgage (ARM) that is added to the adjustment-index rate.
Using margin for acquiring securities is akin to leveraging the existing cash or securities within an account as a guarantee for a loan. Such a loan is secured by collateral and involves a recurring interest rate obligation.
By employing borrowed funds, the investor would be able to increase his potential for both gains and losses.
The margin investing strategy may prove beneficial when the investor believes he can generate a superior rate of return on the investment compared to the interest expense of the loan.
For example, take a scenario in which your margin account calls for an initial margin investment of 60%. If you intend to buy securities valued at $10,000, your margin requirement would amount to $6,000. This amount would then entitle you to raise the remaining $4,000 through a loan from the broker.
This maneuver would make financial sense for the investor on the assumption that the $10,000 borrowed can be used to generate a return on investment that is greater than the amount needed to service the loan.
Of course, if such returns are not realized, the investor is liable to lose the funds in his margin account, which will usually constitute a greater loss than the loss of the security for a regular bank loan—which will normally have a lower security requirement—would represent.
It is important to note that the Securities and Exchange Commission (SEC) has emphasized that margin accounts are inherently risky and may not be suitable for all investors.