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Margin buying is a way of spending more money than one actually has on hand on an investment. This is done by putting a smaller investment down as collateral, and then borrowing money from the broker to make up the rest of the cost of the stocks. Margin buying can be an excellent way to make a lot of money off of a relatively smaller amount of initial capital -- but it can also result in some pretty devastating losses. Let us look at an example to see how margin buying can yield great benefits, and also to understand its downsides.
Imagine we are purchasing a stock for $100, and we are buying it all with our own money. The price of the stock then doubles, leaving our stock worth $200. We have just made a 100% return on our initial investment, and a profit of $100.
Now imagine we only have $25, so we purchase $100 worth of stock using margin buying, with a $75 loan from our broker. The stock price doubles to $200, so our return is actually 700%, minus the $75 plus interest we owe to our broker. So off of an initial investment of $25, we've made nearly $100, or almost quadrupled our initial investment. So margin buying can be a wonderful shortcut to reaping large returns.
On the other hand, imagine a similar margin buying scenario. We are buying $100 of stock, all with our own money. The price plummets to half its initial value, closing at only $50. We've now lost 50% of our initial investment -- a harsh blow, to be sure, but still leaving us with some capital to invest.
Imagine instead that we have only $25, so we purchase the $100 worth of stock using margin buying with a loan from our broker. As the stock price drops below our initial investment, our broker will put out a margin call, requiring us to pay in more to meet the minimum margin requirement. Otherwise they will sell off our securities to cover the loan and we will be left with nothing.
Even if we pay another $25 to cover the minimum margin, as the stock price drops to $50 we will still be left with nothing. Off of our initial investment we have lost fully 100%, leaving us with nothing. So margin buying can be a dangerous path if the market has a bad day or our stock choices are unlucky.
Margin buying has changed since the 1920s, when it had relatively loose regulations and minimum margin requirements were very low. This situation led to a lot of weak investment positions, which in turn helped usher in the Crash of 1929 and the Great Depression. Since then, brokers tend to require higher minimum margins in cases of margin buying, asking investors to put up more initial capital to help protect them against fluctuations in the market. The Federal Reserve Board now has a number of rules handling margin buying, and organizations which self-regulate, such as the NASD and NYSE, have their own rules. These include such things as a mandatory minimum margin -- the New York Stock Exchange requires at least a US$2000 deposit with the brokerage and a cap on leverage, limiting you from borrowing more than 50% of the total investment value.