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Buying on Margin
Investors with a high-risk tolerance don't always have to pay the full price for investments. They have the option to open a margin account, which allows them to leverage their purchases by borrowing up to 50% of the price of a stock from their broker. The stock in the margin account is used as collateral for the loan. The investor then has to pay interest on the loan, but isn't required to pay the loan back until he sells the stock. Buying on margin increases the potential return from a stock - any profit made on borrowed money (less interest fees) is kept by the investor. For example, if an investor wants to purchase 100 shares of a stock that is trading at $50, he can either pay the full purchase price of $5000, or pay $2500 and borrow the other $2500. If the stock then rises to $75, his position is worth $7500, a $2500 gain. If the investor bought the stock with all cash, the investor has made a 50% profit ($2500 on $5000 invested), but if the investor bought on margin, he only invested $2500 and made $2500, a 100% return! (less commissions and interest payments).
Buying on margin gives investors additional financial power, but also carries additional risks. If the stock falls, the investor will watch his equity erode faster than with a cash purchase. To help prevent disasters, brokers will issue a margin call to investors when the value of their investment drops below a certain level (this varies depending on the broker and the security, but it is around a 20-25% drop for most stocks). A margin call requires the investor to either deposit more money in his account, or sell some stock.
The minimum amount of cash required to open a margin account is $2000. |
