BUYING ON MARGIN

You probably know by now that most of your security transactions will be conducted using a broker.  But did you know you could borrow funds from a broker to invest?

When you buy securities on margin, you borrow money from your broker by using your current shares as collateral. This reduces the amount of cash you have to pay up front, allowing you to buy more securities at rising prices.  The process of buying more assets with borrowed money or securities is known as leveraging.

Buying on margin is a risky venture.  Using margins can increase your gains, but also your losses.  To buy on margin, you open up a margin account.  The risk is that the value of your margin securities will become worth less than your loan balance.

Let's say you buy 100 shares at $50 a share on margin.  The total market value is $5,000. You must always have at least half of the total value ($2,500) in your margin account.  This is called equity; the difference between your equity and the value of the securities is your debit balance, the amount borrowed.  If the stock increases to $60 a share, you now have a total market value of $6,000 with $3,500 in equity (current market value minus original debit balance).  This gives you an additional $500 ($3,500 of current equity minus $3,000 of current margin requirement) to receive in cash or buy more stock, giving you an even bigger market value ($7,000) for the same amount of money.

If the stock drops to $40 a share, however, your total value is now $4,000 and your equity is $1,500 (current market value of $4,000 minus original debit balance of $2,500).  When your equity as a percentage of current market value drops below a minimum maintenance requirement (e.g., 25 percent of current market value), you will be required to deposit additional collateral into the margin account.

Investors also look for ways to capitalize on falling security prices.  Let's explore this method next.