Margin Buying

Definition

Margin buying refers to the practice of purchasing securities, such as stocks, by borrowing a portion of the purchase price from a brokerage firm. This allows investors to leverage their capital and potentially amplify their returns, but also carries significant risks.

5 Must Know Facts For Your Next Test

1. Margin buying allows investors to purchase securities by putting down only a portion of the total cost, typically 50% or less, with the brokerage firm providing the rest as a loan.
2. The use of leverage in margin buying can amplify both gains and losses, as investors are effectively trading with borrowed money.
3. Margin calls occur when the value of an investor's margin account falls below a certain level, typically 30-35% of the total value of the securities in the account.
4. The widespread use of margin buying during the 1920s contributed to the rapid rise in stock prices, which ultimately led to the stock market crash of 1929 and the onset of the Great Depression.
5. After the crash, the Federal Reserve and other regulatory bodies implemented stricter margin requirements and other measures to curb the excessive use of leverage in the stock market.

Review Questions

• Explain how margin buying works and the role it played in the stock market crash of 1929.
  • Margin buying allows investors to purchase securities by borrowing a portion of the purchase price from a brokerage firm, typically 50% or less. This use of leverage can amplify both gains and losses, as investors are effectively trading with borrowed money. The widespread use of margin buying during the 1920s contributed to the rapid rise in stock prices, which ultimately led to the stock market crash of 1929 and the onset of the Great Depression. When stock prices plummeted, many investors were unable to meet their margin calls, leading to a cascading effect that exacerbated the market's collapse.
• Describe the role of margin calls in the context of the stock market crash of 1929 and how they impacted investors.
  • Margin calls occur when the value of an investor's margin account falls below a certain level, typically 30-35% of the total value of the securities in the account. During the stock market crash of 1929, as stock prices plummeted, many investors were unable to meet their margin calls, leading to a forced liquidation of their positions. This further drove down stock prices, creating a self-reinforcing cycle of declining values and margin calls. The inability of investors to meet these margin calls contributed to the severity of the crash and the onset of the Great Depression, as the forced selling of securities exacerbated the market's decline.
• Analyze the long-term impact of the stock market crash of 1929 and the regulatory changes that were implemented to address the excessive use of leverage through margin buying.
  • The stock market crash of 1929 and the subsequent Great Depression highlighted the risks associated with the excessive use of leverage through margin buying. In the aftermath of the crash, the Federal Reserve and other regulatory bodies implemented stricter margin requirements and other measures to curb the use of leverage in the stock market. These changes were designed to prevent a similar crisis from occurring in the future and to promote more stable and sustainable growth in the financial markets. The long-term impact of these regulatory changes was a more cautious approach to investing, with investors and brokerage firms being more mindful of the risks associated with margin buying and the potential for leverage to amplify both gains and losses. This shift in market behavior helped to prevent the recurrence of a stock market crash of the magnitude seen in 1929.

Related terms

Leverage: The use of borrowed capital to increase the potential return on an investment. Margin buying allows investors to leverage their funds to purchase more securities than they could with their own capital alone.

Margin Call: A margin call occurs when the value of an investor's margin account falls below a certain level, prompting the brokerage firm to demand additional funds or the sale of securities to bring the account back up to the required margin level.

Stock Market Crash of 1929: The stock market crash of 1929, also known as the Great Crash, was a major economic event that marked the beginning of the Great Depression. Margin buying played a significant role in the build-up and subsequent collapse of the stock market during this period.