Leveraged Investments Are Purchased on the Margin
Buying on margin means buying securities, such as stocks, with funds you borrow from your broker. Investing on margin is similar to buying a house with a mortgage. If you buy a house at a purchase price of $100,000 and put 10 percent down, your equity (the part you own) is $10,000, and you borrow the remaining $90,000 with a mortgage.
If the value of the house rises to $120,000 and you sell, you make a profit of 200 percent. How is that? The $20,000 gain on the property represents a gain of 20 percent on the purchase price of $100,000, but because your real investment is $10,000 (the down payment), your gain works out to 200 percent (a gain of $20,000 on your initial investment of $10,000).
Buying on margin is an example of using leverage to maximize your gain when prices rise. Leverage is simply using borrowed money when you make an asset purchase in order to increase your potential profit. This type of leverage is great in a favorable (bull) market, but it works against you in an unfavorable (bear) market.
Say that a $100,000 house you purchase with a $90,000 mortgage falls in value to $80,000 (and property values can decrease during economic hard times). Your outstanding debt of $90,000 exceeds the value of the property. Because you owe more than you own, you’re left with a negative net worth.
Leverage is a double-edged sword. Don’t forget that you need approval from your brokerage firm before you can buy on margin. To buy on margin, you typically fill out the form provided by that brokerage firm to be approved. Check with the broker because each firm has different requirements.
When you purchase stock on margin, you must maintain a balanced ratio of margin debt to equity of at least 50 percent. If the debt portion exceeds this limit, you’re required to restore that ratio by depositing either more stock or more cash into your brokerage account. The additional stock you deposit can be stock that’s transferred from another account.
The Federal Reserve Board governs margin requirements for brokers with Regulation T. Discuss this rule with your broker to understand fully your (and the broker’s) risks and obligations. Regulation T dictates margin requirements set by brokers for their customers. For most listed stocks, it’s 50 percent.