Margin Stock Definition

Investing in the stock market has made many people rich. It has also made many people poor! Trading stocks has a high risk factor, but it also can give a higher return on investments than most other types of financial instruments, including certificates of deposit (CDs), money market accounts, bonds and savings accounts. When investing, the higher the risk, the higher the chance of making more profit. Low risk investments, such as CDs, money markets and savings accounts pay low rates of return, but the initial principle is secure. However, money used to purchase a stock is fully at risk. An even riskier method of buying stock is to buy stocks on "margin." Using a margin account, an investor can lose more money than he invested, but there is also the opportunity to make a much higher return on investment.

"Margin" Is Borrowing Money

Open a brokerage account to trade stocks and request the option of it being a "margin account." If approved, you can borrow money to purchase stocks. The broker loans the money and charges interest. How much the investor can borrow depends on how much cash he has available in his account plus any stocks he owns that can be used as collateral (the Federal Reserve determines which stocks can be used as collateral for margin loans). A margin account holder can purchase stocks on margin as long as she has at least 50% of the purchase in cash or acceptable stocks as collateral. For example, if a person has $5,000 cash in their account, they can purchase $10,000 worth of stock. Obviously, using a margin account increases an investor's buying power.

Increase ROI

Make a bigger return on investment (ROI) by purchasing stock on margin. Let's clarify this with an example. Suppose you have $100 and you purchase a stock for $100. The stock price goes up to $150, and you sell it. You make $50 profit, which is a 50 percent return on your initial investment. Now, suppose you purchased that $100 stock, but you only pay $50 for it, and borrow the other $50 from your broker. The stock goes to $150 and you sell. Now you've earned a $50 profit on your $50 investment, less a small amount of interest you'll have to pay for the loan. Technically, that's almost 100% return on investment. Of course, you do have to pay back the $50 you borrowed. The point is, you can use your broker's money to leverage more buying power than you would otherwise be able to fund from your own resources.

The Downside

Purchasing stock on margin is more risky than simply buying a stock with cash. Should a stock's price drop substantially that you have purchased on margin, the broker can issue a "margin call," where he will require more cash to be placed in the account as collateral. In a volatile market, stock prices can drop quickly. In a worst-case scenario, you might have to pay the broker for money lost by the decreased stock value. It's possible to lose more money than you have invested in that stock. You will not only be required to repay the full amount of your loan, but also all accrued interest.

Warning

Recognize the risks of buying a stock on margin before you ever attempt a purchase. Know that you could lose more money than you spent buying a stock. You must also pay an interest charge on your loan, and this will be deducted from any profit you make on the sale of the stock. If there is no profit when the stock is sold, you're still responsible for paying the interest. Know that if a broker issues a margin call, you will have a limited time (possibly only 24 hours) to add funds to your account to bring collateral up to at least 50 percent of the value of the trade in either cash or fully paid marginable securities. Also, be aware that in cases where a stock's price drops dramatically, the broker has the right to sell a margined stock to get his money. This may mean selling it at a substantial loss. Firms have the right to force you to liquidate positions in a margin account if the equity in the account drops below the minimum equity requirement. Worse yet, brokers can liquidate securities in your margin account without prior notice! This eliminates the chance to recoup your losses if the market bounces back.

Margin Agreements

Read the margin agreement from your broker very carefully. Be sure you understand the pros and cons of purchasing stocks on margin. It can give you tremendous buying power, but it can also be financially risky. Do not purchase stocks on margin if you do not have the resources to pay the loan in the event of a downturn in the stock price. Invest wisely, and make trades that you won't lose sleep over.