Stocks: What is trading on margin?
To trade on margin, you need a margin account. This is
different from a regular cash account in which you trade using the money in the
account. By law, to open a margin account your broker is required to obtain your
signature. The margin account may be part of your standard account opening
agreement or may be a completely separate agreement. Margin accounts are
brokerage accounts that allow you to pay for part of the cost of buying stock
with money that you, in effect, borrow from your broker. You use the account to
buy on margin, sell short, or day trade. To open the account, you must make a
minimum deposit of at least $2,000, though some brokerages require more. This
deposit is known as the minimum margin.
Once the account is opened and operational, you can borrow up
to 50% of the purchase price of a stock. This portion of the purchase price that
you deposit is known as the initial margin. It's essential to note
that you don't have to margin all the way up to 50%, you can borrow less, say
10% or 25%. Be aware that some brokerages require you to deposit more than 50%
of the purchase price.
Let's say for example, you deposit $10,000 in your margin account. Because you put up 50% of
the purchase price, this means you have $20,000 worth of buying power. Then, if
you buy $5,000 worth of stock, you still have $15,000 in buying power remaining.
You have enough cash to cover this transaction and so you haven't tapped into
your margin. You start borrowing the money only when you buy securities worth
over $10,000.
When you buy on margin, you are essentially borrowing money so you pay interest on
what you borrow but don't have to repay the loan until you sell the stock —
ideally, at a large enough profit to cover the interest. If the value of the
stock that you bought on margin declines, and you don't have
enough assets in your account to cover the margin requirement, you may get a
margin call from your broker. You can keep your loan as long as you want,
provided you fulfill your obligations. First, when you sell the stock in a
margin account, the proceeds go to your broker against the repayment of the
loan, until it is fully paid. Second, there is also a restriction called the
maintenance margin, which is the minimum account balance you must
maintain before your broker will force you to deposit more funds or sell stock
to pay down your loan. When this happens, it's known as a margin call.
Not all stocks qualify to be bought on margin. The Federal Reserve Board
regulates which stocks are marginable. As a rule of thumb, brokers will not
allow customers to purchase penny stocks, Over The Counter Bulletin Board
(OTCBB) securities, or Initial Public Offerings (IPOs) on margin because of the
day-to-day risks involved with these types of stocks. Individual brokerages can
also decide not to margin certain stocks so check with them to see what
restrictions you have on your margin account.
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What is
Leverage?
Leverage is an investment
technique in which you use a small amount of your own money to
make an investment of much larger value. In that way, leverage
gives you significant financial power. For example, if you borrow
90% of the cost of a home, you are using the leverage to buy a
much more expensive property than you could have afforded by
paying cash. And if you sell the property for more than you
borrowed, the profit is entirely yours.
Buying stock on margin is a type of leveraging, as is buying a
futures contract or an option. Leveraging can be very risky,
however, if the investment doesn't perform as you anticipate. At
the very least, you risk losing your own money and must repay any
money you borrowed. And with some leveraged investments, you could
be responsible for even larger losses if the value of the
underlying product drops significantly.
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Next==>>
Advantages
and disadvantages of margin
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