Buying Stock on Margin

There are two ways that you can purchase stock. First, you can pay cash, or you can pay some cash and some borrowed funds.

The second method above is called buying stock on margin. When an investor purchases stock using a margin account they make an initial payment, similar to the downpayment on a house and then borrow the remaining funds to make the purchase. The securities themselves act as collateral for the margin loan.

A concept that you have to understand is the margin requirement. This is established by the Federal Reserve and is the minimum percentage of the total transaction that the investor must pay. Some brokers require more than this minimum. For example, if the margin requirement is 75% and the price plus commission on 100 shares of stock is $1,000, then the investor would need to pay $750 initially for the transaction.

Why buy stock on margin? This is quite simple. Buying stock with someone else's money can create a greater return on your money. If in the example above, you sell the securies for $1,500. If, in the example above, you sell the securities for $1,500 and you use all of your own money, then you would have earned a 50% return ($500 / $1000). If you purchased the stock on margin (75%), you would have earned a 67% return on your money ($500/ $750).

Sounds great right? Well no, not always. If you can make more of a return by using less money, then typically the opposite is true also, you can also lose a greater percentage with less money. Using the same example from above; selling the securities for $750 would result in a 25% loss with an all cash transaction ($250 loss / $1,000). With the margin transaction, the loss would be 33% ($250 loss / $750).