Buying on Margin
You can invest in stocks in different ways. One of those ways is buying on margin. To do that, you borrow up to half the purchase price from your brokerage firm to pay for your purchase. You use your own cash to pay for the other half of the purchase. In other words, buying on margin allows you to use your own cash, plus cash you borrow from your broker, to fund an investment.
If the price of the stock rises, as you anticipate it will when you make a margin purchase, you can sell your shares for more than you paid for them. You repay the loan, plus the interest that has accumulated, and keep the profit. The brokerage firm's profit is a combination of interest on the loan and commissions for the purchase and sale.
But, if the stock's price drops, as it always could, you still owe the full amount of the loan. If you sell at a loss, what you get to keep (if anything) is the difference between the selling price and what you owe your firm. And the longer you hold the loan, the more interest you'll owe. You don't have the alternative of giving the stock a chance to recover as you might if you owned the shares outright.
To buy on margin, you must apply for a margin account at your brokerage firm. All margin trades have to be placed through that account, using your own money and money borrowed from your broker. The firm will require you to deposit a required minimum amount in cash or marketable securities in the account. That amount is never less than $2,000.
The most you can borrow in any transaction is 50% of the purchase price. That requirement is established by the Federal Reserve's Regulation T.
For example, if you buy 1,000 shares at $10 a share with your own money, your total cost would be $10,000. But if you're buying on margin, you could invest $5,000 and borrow the remaining $5,000. If the stock price rises to $15 a share and you sell, the proceeds are $15,000. You repay the $5,000 you owe to your brokerage firm and keep the $10,000 balance (minus interest and commissions). That's almost a 100% profit. Had you invested $10,000 of your own money and sold for $15,000, you would have had a $5,000, or 50%, profit. (Commissions apply in both the margined and non-margined transactions.)
But suppose you were wrong in anticipating how the stock was going to perform. If the price dropped to $7.50 a share, which is as likely a possibility as it rising to $15, you might sell. From the $7,500 you realized from the sale, you'd owe your firm $5,000 plus interest and commissions. That would leave you with less than $2,500, or more than a 50% loss on your investment. If you hadn't used leverage, you'd have $7,500 minus commissions. That's a 25% loss.
As you can see, buying on margin can be very risky despite its potential rewards. It is possible that the value of a stock you bought could drop so much that selling it wouldn't even be enough to repay the loan.
To protect brokerage firms from such losses, the Financial Industry Regulatory Authority (FINRA) requires you to maintain a margin account balance of at least 25% of the market price of any stock you buy to hold in your account. Individual firms can require a higher margin level. In many cases, it's 30%, but it could be more depending on which specific security you're investing in.
If your account's value falls below the required minimum, the firm will issue what's known as a margin call. You must add money to your account to meet the call and bring the maintenance balance back to the required minimum. The alternative is to sell the stock, pay back your broker in full, and take the loss.
For example, if the 1,000 shares you bought for $10 a share with a $5,000 margin loan declined in price to $6 a share, your equity would be $1,000, or just 16.6% of the total market value of your account. If your broker had a 30% margin requirement, you would have to add $800 to bring your equity to $1,800, or 30% of $6,000.
If your firm issues a margin call and you don't respond within the time frame it allows, the firm has the right to sell any investments in your account to meet the call on your behalf. It could be a different security than the one that's causing the margin call. The firm doesn't have to notify you of its intention to sell, and it may act very quickly, especially if the stock price is falling fast.
Your vulnerability to a margin call is a good illustration of why it's essential to be sure you review and fully understand the terms of a margin agreement before you open a margin account.