Buying on Margin

If you want to increase the potential return on a stock investment, you can leverage your purchase by buying on margin. That means borrowing up to half of the purchase price from your broker. If you can sell the stock at a higher price than it cost, you can repay the loan, plus interest and commission, and keep the profit. But if the stock drops in value, you still have to repay the loan. And if you must sell the shares for less than you paid, your losses could be larger than if you had owned the stock outright.

LEVERAGING YOUR STOCK INVESTMENT Leverage is speculation. It means investing with money borrowed at a fixed rate of interest in the hope of earning a greater rate of return. Like the lever, the simple machine for which it is named, leverage lets the users exert a lot of financial power with a small amount of cash.

Companies use leverage — called trading on equity — when they issue both stocks and bonds. Their earnings per share may increase because they expand operations with the money raised by bonds. But they must use some of those earnings to repay the interest on the bonds.

MARGIN ACCOUNTS
To buy on margin, you set up a margin account with a broker and transfer the required minimum in cash or securities to the account. Then you can borrow up to 50% of a stock's price and buy with the combined funds.

For example, if you buy 1,000 shares at $10 a share, your total cost would be $10,000. But buying on margin, you put up $5,000 and borrow the remaining $5,000. If you sell when the stock price rises to $15, you get $15,000. You repay the $5,000 and keep the $10,000 balance (minus interest and commissions). That's almost a 100% profit. Had you paid the full $10,000 with your own money, you would have made a 50% profit, or $5,000.

MARGIN CALLS
Despite its potential rewards, buying on margin can be very risky. For example, the value of the stock you buy could drop so much that selling it wouldn't raise enough to repay the loan.

To protect brokerage firms from losses, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) require you to maintain a margin account balance of at least 25% of the market price of any stock you buy long, to hold in your account. Individual firms can require a higher margin level, say 30%, but not a lower one.

CLOSING THE BARN DOOR
The government and its regulatory agencies are good at figuring out ways to prevent financial disasters — after they happen. The rules and regulations that govern stock trading, for example, were devised in the wake of two major stock market crashes.

If the market value of your equity falls below its required minimum, the firm issues a margin call. You must either meet the call by adding money to your account to bring it up to the required minimum, or sell the stock, pay back your broker in full and take the loss.

For example, if shares you bought for $10,000 declined to $7,000, your equity would be $2,000, or only 28.6% of the total value. If your broker has a 30% margin requirement, you would have to add $100 to bring your equity to $2,100, or 30% of $7,000.

In the market crash of 1929, investors who were heavily leveraged because they had bought on margin could meet their margin calls. The result was panic selling to raise cash, which resulted in further declines in the market. That's one reason the Federal Reserve instituted Regulation T, which limits the leveraged portion of any margin purchase to 50%.

MARGIN MINIMUMS
To open a margin account, you must deposit a minimum of $2,000 in cash or eligible securities. All margin trades have to be conducted through that account, combining your own money and money borrowed from your broker.

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