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.

Advantages and Disadvantages of Margin:
Why use margin? In a word, leverage. Just as companies borrow money to invest in projects, investors can borrow money and leverage the cash they invest. If you pick the right investment, margin can dramatically increase your profit. A 50% initial margin allows you to buy up to twice as much stock as cash in your account. It's not difficult to see how there is the possibility to make significantly more money in a margin account than you can by trading with a cash account. It simply depends on whether your stock rises or not. Also, interest on margin loans at most brokerage accounts are lower than credit cards and auto loans. If you ever need money and you are not ready to sell your stocks, you can take out a margin loan without a credit check.

The best way to demonstrate the power of leverage is with an example. Lets say you bought $20,000 worth of securities using $10,000 of margin and $10,000 of cash. You bought it at $100 and you feel that it will rise dramatically. Normally, you'd only be able to buy 100 shares (100 x $100 = $10,000) with cash account. Since you're investing on margin you have the ability to buy 200 shares (200 x $100 = $20,000).

The next month, share price went up 20% and you sell it at $120 giving you  $24,000 total (200 x $120). After paying back your broker the $10,000 you originally borrowed, you'll net $14,000, of which $4,000 is profit . That's a 40% return when the stock went up 20%. To simplify this transaction, we didn't take into account commissions and interest. Otherwise, these costs would be deducted from you profit.

Of course leverage can go both ways, if we take the same scenario but instead of stock going up if the price of the stock went down 20% to $80. You would have a loss of 40% instead of 20%.

What is a Margin Call?
Buying on margin can be potentially profitable but also potentially risky. To protect themselves, brokers issue a margin call if your margin account falls below the required maintenance level or a specific percentage of its original value. The New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) set that requirement at 25%, and some brokerage have stricter limits. You could get a margin call, for example, if the market price of the stock you bought on margin drops significantly. If you get a margin call, you must deposit additional money to meet the call, bringing the balance of the account back up to the margin required. Otherwise, your stock may be sold at a loss, and your broker repaid in full.

For example, Let's say you purchase $20,000 worth of securities by borrowing $10,000 from your brokerage and paying $10,000 yourself. If the market value of the securities drops to $15,000, the equity in your account falls to $5,000 ($15,000 - $10,000 = $5,000). Assuming a maintenance requirement of 30%, you must have $4,500 in equity in your account (30% of $15,000 = $4,500). Thus, you're fine in this situation as the $5,000 worth of equity in your account is greater than the maintenance margin of $4,500. But, assume the maintenance requirement of your brokerage is 40% instead of 30%. In this case, your equity of $5,000 is less than the maintenance margin of $6000 (40% of $15,000 = $6,000). As a result, the brokerage may issue you a margin call.

If you do not meet a margin call for any reason, the brokerage has the right to sell your securities to increase your account equity until you are above the maintenance margin. Even scarier is the fact that your broker may not be required to consult you before selling. Under most margin agreements, a firm can sell your securities without waiting for you to meet the margin call. You can't even control which stock is sold to cover the margin call. Because of this, it is imperative that you read your brokerage's margin agreement very carefully before investing. The agreement explains the terms and conditions of the margin account including how interest is calculated, your responsibilities for repaying the loan, and how the securities you purchase serve as collateral for the loan.

**Recommended Reading**

The Richest Man in Babylon This classic book bring some basic principles of financial planning to life through the use of stories, using the wealth of ancient Babylon as a backdrop. The advice itself is all still sound today, which is remarkable, given the book's age. This would be a wonderful book for anyone who needs to learn some of the basic lessons of earning, saving, and spending money (or needs to be reminded of them!), but doesn't respond well to dry manuals.

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