When you buy stock on margin, you are borrowing money from your stockbroker to help fund the purchase and are pledging the stock you are buying as the collateral to secure the loan. Investors buy on margin so they can control more shares than they could if they made a cash purchase. You must meet certain minimum requirements before buying stocks on margin.
Since your brokerage is lending you money for a stock purchase, you must satisfy their standards for creditworthiness. These standards vary from broker to broker, but in general a broker won’t allow someone with a poor credit history to buy stocks on margin. You also must satisfy the margin trading requirements set by federal securities regulators and the stock exchanges. At a minimum, you must put up in cash 50 percent of the price of the securities you are buying. This is called the initial margin.
Going forward, you must keep at least 25 percent of the original purchase price of your securities in your margin account as a maintenance margin. The equity worth of your stock satisfies this requirement if the current market value of your stock exceeds 25 percent of your original purchase price. Your broker can require a higher initial margin and higher maintenance margin. Stock exchanges require a minimum $2,000 investment for opening any margin account but brokerages can require a larger minimum. If the stock rises in price the margin investor stands to profit handsomely, but if it falls far below the original per-share purchase price he can lose more than he invested.
Good & Bad
If an investor buys 200 shares of a $100 stock for $20,000, he pays $10,000 in cash and the broker lends him the other $10,000 on margin. If the investor sells his stock at $125 per share or $25,000, he gets back his $10,000 cash investment, repays the broker’s $10,000 margin loan and pockets the $5,000 profit for a 50 percent return on his cash investment. But if his stock dropped to $50 and he sold, he would get $10,000. After repaying the margin loan, he would have lost 100 percent of his investment. If the stock dropped to $25 and he sold, he would get only $5,000 but would still owe the broker $10,000. After repaying the broker, he would have lost 150 percent of his $10,000 investment. Failure to repay a margin loan would hurt the investor’s credit rating.
To satisfy regulatory requirements, you must have at least $5,000 in equity worth in your original $20,000 margin account as the maintenance margin. If your $100 stock plunged to $20 a share, you would face a “margin call” from your broker. At $20 per share, the equity worth of your 100 shares of stock would only be $4,000. In this case, the broker would issue a margin call requiring you to pay cash to make up the $1,000 shortfall. If you couldn’t meet the margin call, the broker can sell enough of your stock to make up the shortfall.