What is Buying on Margin?
Buying on margin refers to borrowing from a brokerage firm (through a margin account) to make an investment.
How Does Buying on Margin Work?
You want to buy 1,000 shares of Company XYZ for $5 per share but don't have the necessary $5,000 -- you only have $2,500. If you buy the shares on margin, you essentially borrow the other half of the money from the brokerage firm and collateralize the loan with the Company XYZ shares. This original loan amount as a percentage of the investment amount is called the initial margin.
If the value of the Company XYZ shares drops past a certain point, say 25% of the original $5,000 value (or $1.25 per share; this point is called the maintenance margin), the brokerage firm may make a margin call, meaning that within a few days you must deposit more cash or sell some of the shares to offset all or part of the difference between the actual stock price and the maintenance margin. The broker does this because it has lent you $2,500 and wants to mitigate the risk of you defaulting on the loan. Federal Reserve regulations and the broker's internal policies determine the initial margin and maintenance minimum percentages.
Getting a margin call means that not only do you have to pay back the original $2,500 of principal eventually, but you have to pay the margin call. However, if the stock rises from $5 to, say, $15, you've just made $10,000 without investing all of your own money.
Margin accounts must follow a margin agreement, which the investor must sign, as well as regulations imposed by FINRA, the Federal Reserve, and even the New York Stock Exchange.
Why Does Buying on Margin Matter?
Buying on margin allows investors to make investments with their brokers' money. They act as leverage and can thus magnify gains. But they can also magnify losses, and in some cases, a brokerage firm can sell an investor's securities without notification or even sue if the investor does not fulfill a margin call. For these reasons, margin accounts are generally for more sophisticated investors who understand and can handle the risks involved.