Trading on margin is a way of increasing the impact of your investment dollars, because you only put up part of the money to buy shares of stock. Margin trading allows you to invest less and make just as much money. While that sounds great, there’s a catch: When you buy stock on margin, you multiply your risk. You also have to follow some strict rules set up by government agencies, stock exchanges and your broker.
"Margin" is the money you contribute to buy shares on margin. You get the rest of the money by borrowing it from your broker. This costs a little extra, because brokers charge interest when they loan you money. Suppose you have $3,000 to buy shares of stock. If you purchase shares for cash and the stock goes up by 20 percent, you make $600. But if you borrow another $3,000, you can get $6,000 worth of the stock. If the stock climbs 20 percent, you make $1,200.
Before you can try your hand at buying stocks on margin, you have to open a brokerage account that lets you borrow money from the broker. This kind of trading account is called a margin account, and it comes with strings attached. Since the broker is loaning you money, your credit is checked and you have to sign a margin agreement that states the terms and conditions for borrowing the money. It also turns all account assets into collateral for the money your broker lends you.
The Federal Reserve Board won’t let you buy stock on margin unless you put up at least 50 percent of the money. Brokers can ask for more. In fact, if a stock looks especially risky, a broker might refuse to let you buy it on margin. The Financial Industry Regulatory Authority requires investors to have at least $2,000 or 100 percent of the value of a trade in their accounts to buy on margin, whichever is less. Sometimes brokers want more. Day traders, for example, might have to have $25,000 in their margin accounts.
If shares bought on margin lose value, you might get a margin call. Stock markets like the New York Stock Exchange say you must keep a minimum maintenance margin of 25 percent. This means if your equity in the stock dips under 25 percent because the stock price falls, your broker must act. Brokers usually send you a margin call to give you a chance to add money to your account, but they don’t have to. Once the equity falls below 25 percent, brokers can sell the stock without telling you to recover the money you borrowed.