One confusing and potentially risky area of investment involves margin stock trading. A margin stock must meet federal and stock exchange guidelines for margin trading. Although potentially lucrative, investing in margin stocks can be a big risk, as the investor may end up financially responsible for losses.
There are several requirements for a stock to be traded on margin. These requirements help mitigate, but do not remove the risks, of trading with this type of account. Accounts that can be traded on margin typically include National Security Exchange stocks, stocks traded in the national market, and certain stocks approved by the Board of the brokerage. Brokers that deal in margin stock trading typically have detailed information about what stocks can be traded legally on margin.
In general investing, an investor takes a certain amount of money and buys stock equal to the money's value. Margin stock, by contrast, allows the investor to borrow money from a brokerage, often up to 50% of the total stock buy. This means that instead of buying $50 US dollars (USD) worth of stock with $50 USD, an investor can buy $100 USD worth of stock by investing $50 USD and borrowing $50 USD. The high risk leads many buyers to borrow far less than the allowed amount.
In an ideal situation, buying margin stocks allows an investor to enter markets he or she could not regularly afford by increasing the buying power, and thus the potential profits of the investor. For example, if a person buys $50 USD worth of non-margin stock and sells it at $70 USD, he or she will make a profit of $20 USD. Using a margin account, that same person could buy $100 USD worth of margin stock for a $50 investment, sell it at $140 USD, pay back the borrowed $50 USD, plus interest of about $4 USD, and still have made $36 USD of profit.
When stocks go up, margin trading can be extremely lucrative and double the buying power of an investor. However, stocks are anything but predictable, leading to serious risk in margin trading. If in the example above, the price of the stock dropped to $30 USD after purchase, the non-margin investor would lose $20 USD of their original $50 USD investment. The margin investor, however, is still responsible for the initial borrowed amount, plus interest. If $100 USD worth of stock dropped to $60 USD, a margin borrower would lose $44 USD after repayment of the loan and interest.
Due to the high risk, most brokerage firms require investors to keep a certain amount of cash or stock collateral in order to pay for high losses on margin stock. This amount may vary based on the amount of the investment and the brokerage, but is frequently around 30% of the borrowed amount. If this collateral, called maintenance, drops below the required amount, a brokerage can usually request an immediate deposit that would return the balance to the required level. If this deposit, known as a margin call, isn't made, the broker has the right to liquidate shares to make up the debt without consulting the investor.