Margin Accounts

Buying stocks on margin is a fancy way of saying that you're borrowing money to buy stocks. Stock brokerage firms provide a special mechanism for doing this by opening a margin account for you. With a margin account you can partially pay for the stock purchase and the brokerage firm lends you the rest. The stock is kept as collateral in the margin account. How this type of account works is illustrated in the following example:

Example Jerry decides he wants to purchase $20,000 worth of stock in the Laugh Corporation. However, Jerry only wants to use $10,000 of his own cash to purchase the stock. He goes to see his broker, George, who reminds Jerry that he has a margin account set up with George's brokerage firm. Jerry uses his $10,000 and borrows the other 50 percent, $10,000, from the brokerage firm to purchase the stock. The Laugh Corporation stock is kept in the margin account as collateral.

Sounds pretty good so far, doesn't it? Actually, buying stocks on a margin has its pluses. Mainly, it allows you to purchase stock you may not have the cash for and end up with a bigger profit percentage because your initial investment was lower than if you had to come up with entire purchase price from your own funds. That's the good news. However, buying stocks on margin is much riskier than simply buying stocks outright.

If you buy stock on a margin account and the price of the stock goes down, you lose a percentage of the money you invested and you also owe money to the lender. Let's follow this scenario through the example:

Example Jerry purchases $20,000 worth of Laugh Corporation with $10,000 of his own money and with $10,000 borrowed on a margin account with his broker George. Jerry decides he has to cash in a substantial piece of his portfolio because he's buying a mansion on the beach. Unfortunately for Jerry the value of his stock has dropped to $10,000. Jerry now owns stock worth $10,000, but he also owes the $10,000 he borrowed to buy the stock, using his margin account. Jerry has not only lost his entire original $10,000 investment, but he must also pay commissions and interest on the borrowed money, so he's actually out $10,000+.

The above example is only part of the risks associated with buying stocks on margin. If you own stocks through a margin account, federal law requires that your equity in the account be at least 25 percent of the stock's current market price. (Brokerage firms can, and often do, require that a larger equity amount is maintained.) What happens if your equity drops below 25 percent? You have to pay back part of the loan. You can pay in cash, but the more typical scenario is that your broker will have to sell your stock to pay off the amount owed. In addition, the stock is often sold at a lower price, compounding the damage to your investment. The following example illustrates how this works.

Example Jerry purchases $20,000 worth of Laugh Corporation with $10,000 of his own money and with $10,000 borrowed on a margin account with his broker, George. Unfortunately for Jerry the value of his stock has dropped to $12,000. His equity in the margin account is now below 25 percent of the value of the stock ($12,000 (what the stock is worth) - $10,000 (the amount Jerry borrowed to buy the stock) = $2,000).

It's probably pretty clear that there is quite a bit of risk associated with buying stocks on a margin account. If you decide to invest in stocks through this method, you should always make sure you offset the profit that can be made with the risks you will incur. If the balance is not clearly on the side of profit, you should steer clear, particularly if the age and stage of your life doesn't support the risk.

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