Buying Stocks on Margin Gives Great Reward Potential that Comes with a Great Risk

Buying stocks on margin is a lot like being at a black jack table at Caesars Palace and getting an Ace on your first draw. Wouldn't it be great if at that very moment you had the option to "borrow" some extra money to throw down on the table? Well if the next card is the right one, it would be ideal. However, if the next card is not right, you are out your original bet as well as the additional money you borrowed to increase the bet.

While buying stocks on margin isn't really the same thing as gambling in Las Vegas, it does nonetheless represent a great deal of risk. And as the saying goes, "With great risk, comes great reward."

When you buy stocks on margin you are actually taking a loan from your broker with the promise that you will pay that loan back (with interest) at a later date. In order to trade stocks on margin, you have to have a margin account and many times this can be established when you first open your brokerage account. There will be a minimum deposit amount of $2,000 that will have to be made before you can buy stocks on margin and many brokerages have an even higher requirement. Therefore, you need to be sure to check that with your broker before you consider trading on margin.

Once you have your margin account established you can then begin to buy on margin by borrowing up to 50 percent of the purchase price of a stock. A word of warning here though, many brokers will make you deposit more than 50 percent of the total purchase price. Once the trade has been made you can keep the loan as long as your minimum account balances, also known as the maintenance margin, is maintained. When this level is breached by the stock price falling too far you get a margin call. When this happens, you either have to fund the account with more money, or you have to sell off some stock in order to get your account square again.

If however the stock goes up all is good. Once you sell the stock you will first have to pay back the loan with interest to the broker, but the rest will be yours to keep. Most investors only use the buying on margin strategy for the short term because of the interest. If you hold a stock too long, the interest accrues and really beginnings to add up.

Not every stock that is publicly traded will qualify to be traded on margin. Each brokerage has their own rules on this, but in general, no penny stocks (stocks trading under $5.00 per share), over the counter stocks (OTCBB or Pink Sheets), or Initial Public Offerings (IPOs) can be purchased on margin. Your broker may also have a list of additional stocks that are not allowed to be bought on margin, but a quick check with your broker will tell you for sure whether or not you can buy a certain stock on margin.

So you have an ace, how good do you think your next card will be? If you really feel strongly, you can always take a loan from the dealer (aka your broker) and buy that stock on margin. Just make sure you know the potential risk that comes with the potential reward.

Source: SEC.gov, Investor Tips: Margin - Borrowing Money to Pay for Stocks, SEC.gov