Borrowing money from your broker and using that money to purchase stock, is buying stock on margin. A margin account is designed to allow you to borrow money against the securities (stocks, bonds, etc.) you currently own or intend to purchase (or sell short). Thus, investors who purchase on margin initially pay only a portion of the full transaction price. Margin requirements or the amount you must deposit on equities and mutual funds, are generally 50% of the market value of the securities. In other words you can purchase $20,000 worth of marginable securities with only $10,000 of your own cash.
Why do investors buy stocks on margin?
The reason is simple; to take advantage of leverage. Using the example above, by putting up only 50% of the market value or $10,000 you are able to benefit from a future price rise on the full $20,000 invested. Thus, as a percentage of the money you've invested, your potential profit is greater than if you purchased the shares outright. However, your potential loss is also greater.
Example of a Margin Transaction in a Listed Security:
Assume you buy 1,000 shares of Company XYZ on margin. Shares of Company XYZ are currently trading at $3.00.
|Total Cost:||to purchase XYZ shares||$3,000 (A)|
|Less:||your broker's maximum loan
(50% of $3.00 * 1,000 shares)
|Equals:||your margin requirement||$1,500|
In the event your shares were to fall below the $2.00 level you will face what is known as a margin call. This is due to the fact that your broker is only permitted to loan you 40% of the market value of your shares under $1.99 to $1.75, as opposed to 50% on securities above $2.00 (see Maximum Loan Value in Getting Started in the Stock Market Section). As a result, you are now required to ensure that the level of margin or amount you put up is equal to 60% of the original total purchase cost of the shares. The example below should help to illustrate the point further.
Example of a Margin Call
Assume Company XYZ's shares fall to $1.90.
|Total Cost:||to purchase XYZ shares (A above)||$3,000|
|Less:||your brokers revised maximum loan
(40% of $1.90 * 1,000 shares)
|Equals:||your total margin requirement||$2,240|
|Less:||your original margin deposit (B above)||$1,500|
|Equals:||Net Margin Deficiency
(amount for which margin call is issued to you)