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 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 the purchase price, the broker will
require you to add money to your margin account sufficient to
restore its value to that minimum level. That's a
margin call.
If you don't have enough
cash to meet a margin call, you'll have to sell off assets in your margin account — or your broker will sell them if you don't act on the call. In a down market, that could mean huge 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
