Why is buying stocks on margin considered riskier than traditional investing?

 purchasing power and allows you to use someone else's money to increase leverage. Trading on margin confers higher profit potential than traditional trading but also greater risks. Buying shares on margin amplifies the effects of losses. Additionally, the broker may issue a Margin Call, which requires you to liquidate your position in a stock or face more capital to hold your investment.

 Suppose you have $ 10,000 in your margin account, but you want to buy stocks that cost more. The Federal Reserve has an initial margin requirement of 50%, which means you have to cover at least half of the money for a stock purchase. This requirement gives you the ability to purchase up to $ 20,000 worth of stock, effectively doubling your purchasing power.

 After making the purchase, you own $ 20,000 in stock and owe $ 10,000 to your broker. The value of the shares serves as collateral for the loan he gave you. If the stock price rises to $ 30,000 and you sell it, you keep what's leftover after repaying your broker (plus interest). Your income is $ 20,000 (minus interest expense) for a 100% return on your initial $ 10,000 investment. If you initially paid the entire $ 20,000 yourself and sold for $ 30,000, your profit is only 50%. This scenario illustrates how the leverage conferred by buying on margin amplifies your earnings.

 Leverage amplifies losses in the same way. Let's say the stock price drops to $ 15,000 and you sell it to avoid further losses. After you pay your broker the $ 10,000 you owe him, your proceeds go up to $ 5,000. You have lost half of your original investment. With traditional investments, however, a drop in price from $ 20,000 to $ 15,000 represents only a 25% loss.

 Another risk of buying stocks on margin is the dreaded margin call. In addition to the initial margin requirement of 50%, the Financial Industry Regulatory Authority (FINRA) requires a maintenance margin of 25%. You must always have 25% equity in your shares on margin. Your margin agreement with your broker may require a higher maintenance margin than the FINRA minimum. If the value of your shares falls and your equity falls below the level required by FINRA or your broker, you may receive a margin call, which requires you to increase your capital by liquidating shares or contributing more money to your account.

 Returning to the example above, assume your broker's maintenance margin requirement is 40%. Since you owe your broker $ 10,000, a drop in the share price from $ 20,000 to $ 15,000 reduces your equity to $ 5,000. That's only 33% of the stock price - you fell below the 40% low. If you cannot or choose not to contribute more capital to cover the margin call, your broker has the right to sell your shares and does not need your consent.

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