Buying on margin involves borrowing money from a broker to purchase stock. A margin account increases your purchasing power and allows you to use someone else's money to increase financial leverage. Margin trading confers a higher profit potential than traditional trading but also greater risks. Purchasing stocks on margin amplifies the effects of losses. Additionally, the broker may issue a margin call, which requires you to liquidate your position in a stock or front more capital to keep your investment.
Suppose you have $10,000 in your margin account, but you want to buy stock that costs more than that. The Federal Reserve has a 50% initial margin requirement, meaning you must front at least half the cash for a stock purchase. This requirement gives you the ability to purchase up to $20,000 worth of stock, effectively doubling your purchasing power.
After you make the purchase, you own $20,000 in stock and you owe your broker $10,000. The value of the stock serves as collateral for the loan he has given you. If the stock price increases to $30,000 and you sell it, you keep what remains after paying back your broker (plus interest). Your proceeds equal $20,000 (minus interest charges) for a 100% gain on your initial investment of $10,000. Had you initially paid for the entire $20,000 yourself and sold at $30,000, your gain is only 50%. This scenario illustrates how the leverage conferred by purchasing on margin amplifies gains.
Leverage amplifies losses in the same way. Suppose the stock price decreases to $15,000 and you sell it to prevent further losses. After paying your broker the $10,000 you owe him, your proceeds come to $5,000. You lost half your original investment. With traditional investing, however, a price drop from $20,000 to $15,000 only represents a 25% loss.
Another risk of purchasing stocks on margin is the dreaded margin call. In addition to the 50% initial margin requirement, the Federal Reserve also requires a maintenance margin of 25%. You must have 25% equity in your margin stocks at all times. Your margin agreement with your broker may call for a higher maintenance margin than the Fed's minimum. If the value of your stock decreases and causes your equity to fall below the level required by the Fed or your broker, you may receive a margin call, which requires you to increase equity by liquidating stock or contributing more cash to your account.
Returning to the example above, assume your broker's maintenance margin requirement is 40%. Because you owe your broker $10,000, a drop in the stock price from $20,000 to $15,000 decreases your equity to $5,000. That is only 33% of the stock price – you have fallen below the 40% minimum. If you cannot or choose not to contribute more capital to cover the margin call, your broker is entitled to sell your stock, and he does not need your consent.