What Is a Market Margin?
The term margin in the stock market refers to buying stocks with borrowed money. Investors cannot borrow 100 percent of the cost of stocks, but a margin loan to pay for a portion of a successful stock investment will boost the return to an investor. Using margin to buy in the stock market leverages an investors investment dollars.
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Effects of Leverage
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Leverage is the ability to control a larger amount of an investment than the available capital held by an investor. For example, with two-for-one leverage, an investor with $10,000 in his brokerage account could buy $20,000 worth of stock. If that stock then gained 10 percent in value, the investor would earn 20 percent on his $10,000 investment. The more leverage an investor can use, the larger the possible gain on the amount of cash invested.
Margin Accounts
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Stock market rules allow investors to use leverage in a margin account from a stock brokerage firm. The account provides leverage by allowing an investor to fund a portion of stock investments with a margin loan. Brokerage margin loans are automatic in a margin account if an investor places a order for more stock than she has cash in the account. The loan does not have to be repaid until investments are sold and the loan carries a competitive rate of interest.
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Margin Limits
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The Securities and Exchange Commission limits the amount an investor can borrow through a margin loan to buy stocks. The basic rule is two times leverage, or a margin loan for 50 percent of the value of stock purchased. A brokerage account designated as a pattern day trading account can use up to four times leverage for day trading purposes. The SEC has set a minimum margin of 25 percent investor equity. If an investor's stock investments decline in value, the percentage of investor money in the account will also decline. Investor equity is the account value minus the outstanding margin loan. That equity can fall no lower than 25 percent of the account value.
Dangers of Using Margin
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Leverage cuts both ways. In the same manner that using a margin loan increases profits if share prices increase, the leverage magnifies losses if the stock declines. At the extreme, a 50-percent drop in the price of a stock is a 100-percent loss of investor equity, but a broker will not let an investor's account fall below the minimum equity level. The broker will issue a margin call, asking for more money to be deposited in the account. Using a margin loan gives the broker the right to sell any security in the account if the broker believes losses will continue to grow. Buying stocks on margin requires close monitoring by the investor.
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