When you buy on margin, you establish a margin
account with your broker and deposit at least $2,000 in cash or
qualified securities, such as stocks or bonds. When you buy a
new stock through the account, you can choose to put up only some
of the money and borrow the rest — up to 50% — from
your broker. The amount you borrow is called a
margin
loan,
and you pay interest on it.
If
the price of your new stock goes up, you sell it, repay your margin
loan, and pocket the rest, minus brokerage fees and loan interest.
When the strategy works well, your return can be much greater
than it would have been had you paid the full cost with your own
money. That’s an example of using
leverage
to your advantage.
If the price of the stock drops, you can
wait to see if the price will go up again. But since you’re
paying interest on the borrowed amount, the longer you wait, the
more the margin loan will cost you, eroding any future profits.
And, if the value of the stock drops below a certain point, which
is a preset percentage of your equity, your firm will require
you to add enough money to your margin account to bring the value
up to that minimum level. That’s a
margin
call.
Your equity is the difference between the market
value of the stock and the amount of your margin loan.
If you don’t
have enough cash to meet a margin call, or if you
don't respond to the call within the time you're
given, your firm will sell off assets in your margin
account. In a down market, that could mean major
losses.
If
the price of your new stock goes up, you sell it, repay your margin
loan, and pocket the rest, minus brokerage fees and loan interest.
When the strategy works well, your return can be much greater
than it would have been had you paid the full cost with your own
money. That’s an example of using
