Risk is the engine of the stock market. Without risk, there would be no way to make money as your stock prices rise. Of course, the same risk that inflates stock prices one day can deflate them the next. For the average stock market investor, the normal risk of the market is enough to satisfy their financial goals without keeping them up at night. But for high-rolling investors who want to make large amounts of money quickly -- and fully understand the serious risks involved -- nothing beats buying on margin.
Buying on margin is borrowing money from your stockbroker to buy stock. Essentially, it's a loan from your broker [source: Investopedia]. Here's an example of how buying on margin works: Your broker can loan you up to 50 percent of the price of a stock. So if the stock price is $100,000, you'll only have to pay $50,000 and your broker will cover the other $50,000. If the stock price increases to $125,000, you make a 50 percent return on your investment! But if the stock price drops to $75,000, you've lost 50 percent of your investment -- and you owe interest on the loan (currently 2 percent) from your broker, plus charges and fees [source: Bankrate.com].
Buying on margin is deeply risky. You not only have the potential of losing your entire investment plus interest, but losing even more money through something called a margin call. To have a margin account, the Federal Reserve Board requires that you always have enough money in your account to cover the maintenance margin. At a minimum, you must have enough cash (equity) in your margin account to equal 25 percent of the total price of the stock you own. If you don't have enough cash in the account, your broker can issue a margin call requiring you to deposit enough money to reach the 25 percent maintenance level.
Using our example above, if you buy $100,000 of stock on margin, you only need to pay $50,000. Seems like a great deal, especially if the stock price goes up. But what if your stock drops to $60,000? Suddenly, you've lost $40,000, leaving you with only $10,000 in your margin account. The rules state that you need to have at least 25 percent of the $60,000 stock value in your account, which is $15,000. So not only do you lose $40,000, but you have to deposit an additional $5,000 in your margin account to stay in business.
In the next section, we'll read the fine print about margin calls and discover why they can be so dangerous to investors.