Buying On Margin

Buying a stock on margin is a transaction in which a purchaser buys stocks by paying a percentage of the price and pledging the security to guarantee payment of the balance of the price. Buying stocks on margin is inherently risky and not for the faint of heart.

Let me give you a specific scenario to show you how buying on margin works. Suppose you want to buy 100 shares of a stock that costs $50 per share. Normally, you would need $5,000 (plus commission) to purchase the stock. If you want to buy the stock on margin though you can borrow up to $2,500 (50%) of the purchase price and pay the remaining $2,500 yourself. If the stock goes up to $75 and you sell it, you would be able to pay the $2,500 (plus interest) and keep roughly $5,000 (a 100% gain).  So, as you can see, buying on margin can greatly enhance your investing returns.

On the other hand though, if your stock starts to fall, you may be hit with a margin call. This ordinarily happens when the value of your stock falls below 30 percent of your total purchase price. Your broker will immediately demand that you deposit additional funds in order to bring your collateral back to the required amount. If you are unable to come up with the money, often by the next day, your broker will sell your stock and use that money to pay for the initial loan. Your permission is not required to do this and the transaction will probably occur at a price and time not beneficial to you. Let's go back to the previous scenario. Let's say our $50 stock falls to $35. At this point, your broker will ask you to come up with money necessary to cover your margin. Let's imagine you can not come up with the money, and the broker sells your stock the next day for $33 a share. From this money he will take the initial $2,500 plus interest. From your initial $2,500 you would only have $800 left (a 68% loss.)Unless you do not have enough money to invest and you are absolutely determined to buy on margin you should not use this strategy (especially if you do not have considerable experience.) If you go through with it, invest money you can afford to lose, keep a close eye on your stocks, and be ready to bail at the first sign of trouble before a margin call causes you to lose a significant amount of money.

Lester said:

Buying on margin, buying puts and calls, or trading commodities are not investing, they are speculations. See THE INTELLEGENT INVESTER