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Understand How Trading on Margin
Works
Let's say you buy a stock for $50 and the price of the stock subsequently rises to $75. If
you bought the stock in a cash account and paid for it in full, you will have earned a 50
percent return on your investment. But if you bought the stock on margin - paying $25
in cash and borrowing $25 from your broker - you will have earned a 100 percent return on the
money you invested after repaying the $25 loan. Of course, you would still owe your broker
interest charged on the $25 loan.
The downside to using margin is that if the stock price decreases, substantial losses can
mount quickly. For example, let's say the stock you bought for $50 falls to $25. If you
fully paid for the stock, you will have lost 50 percent of your money. But if you bought
on margin, you will have lost 100 percent after repaying the $25 loan plus you still must
come up with the interest you owe on the loan.
In volatile markets, investors who put up an initial margin payment for a stock may, from
time to time, be required to provide additional cash or securities if the price of the
stock falls. Some investors have been surprised to find out that their brokerage firm has
the right to sell their securities that were bought on margin - without any prior
notification and potentially at a substantial loss to the investor. If your broker sells
your stock after the price has plummeted, then you've lost out on the chance to recoup
your losses if the market bounces back.
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