Financial Education

Investors have the option to invest borrowed money, leveraging the return on their transactions. Brokers provide margin funds for this purpose.

In a margin transaction, the investor posts a portion of the cash needed to buy a security and borrows the rest. The stock or security purchased serves as collateral on the loan.

The Federal Reserve Board determines the margin requirement, or maximum portion of any transaction that can be made using margin. A lower margin requirement permits higher borrowing levels. Currently the margin requirement is 50%, meaning investors can borrow up to half the funds for a transaction.

Using margins exaggerates the return on an investment. For example, buying 100 shares of stock for $100 per share at 50% margin, the investor uses only $5,000 cash. The investor’s cash is also called the “equity” in the transaction.

If the stock rises to $110, the shares are worth $11,000 but the investor would still only owe $5,000 (plus some interest.) The equity has increased to $6,000 - which is a 20% gain even though the stock itself rose only 10%.

Of course, the same phenomenon works in reverse. If the stock falls 10% to $90, there is only $4,000 of equity and the investor loses 20% when the stock has lost just 10%.

For more information, see all articles on: Investing in Stocks, Securities Regulation, Security Selection, Trading Execution

See also:

Margin Calls

How Non-Cash Investing and Financing Transactions are Treated on the Statement of Cash Flows

Profit Margins

Analyzing Sales

The Contribution Margin