When the stocks you bought on margin increase in value, everything is fine. You can use the increase in value to repay the loan portion of the investment to your broker. If your $5,000 margin investment in $10,000 in stocks goes up to $15,000 in value, you can repay the loan and own all the shares you have.
If the stock's value drops, however, you can get into trouble quickly. That's because of the minimum margin. The Financial Industry Regulatory Authority (FINRA) requires a minimum investment of $2,000 in margin accounts -- and many brokers will make you pay more. The Federal Reserve Board only allows you to borrow up to 50 percent of the total cost of stocks you buy on margin. Finally, FINRA also requires a maintenance minimum of 25 percent, which is the minimum amount of cash that must be held in a margin account relative to the value of the stocks. Brokers can set different minimum margins and maintenance minimums, as long as they are more stringent than the federal rules. They often tie maintenance minimums to the perceived volatility of the stock -- if they think there's a good chance the stock's value will drop drastically, the maintenance minimum might be as much as 75 percent.
This can be a problem because the value of your stock declines comes out of your equity first. To use our example scenario, if the stock declines to $80 per share, your original $10,000 in shares is now only worth $8,000. However, this loss of value comes out of the $5,000 equity you started with. That means you're left with only $3,000 in equity. Since the total value of the stock is now $8,000, you've got 37.5 percent equity in the account, so you meet the 25 percent maintenance minimum. However, if you cash out your stock now, you'll only get back $3,000 out of your original $5,000 cash investment.
If the stock's value drops even further, things get much worse. Imagine that the stock declines to $60 per share. The stocks you own are now only worth $6,000, losing another $2,000 in value. That $2,000 again comes out of your equity, which started out at $5,000, dropped to $3,000 and is now down to $1,000. At this point, your $1,000 in equity is less than 25 percent of the value of the account. That's when the broker issues a margin call (in the form of a phone call or e-mail). Read the next section to find out why a margin call could spell disaster for your investment portfolio.