Many companies have issued shares of stock. But with so many shares available, it can be hard to determine which ones to buy. It can leave some investors feeling as if they are missing out on some good companies. To help combat that feeling, many investors do something called "trading on margin."
Margin purchasing power refers to the amount of stock that you can buy with the amount of money in your account. The Federal Reserve Board caps the amount of margin in accounts at 50 percent. This means for every dollar you have in actual value, you may own $2 of stock.
Calculating margin purchasing power is fairly straightforward. The account value multiplied by two equals your purchasing power. For example, if you had an account worth $10,000, you'd multiply $10,000 by two to equal $20,000 of purchasing power. Investors figure their margin percentage by dividing the cash value of their stock by the total value of the stock you own. For example, if you owned $30,000 worth of stock and had $20,000 in the account, the equation is $20,000 divided by $30,000 for 66.67 percent.
Purchasing stocks on margin is like purchasing stocks on a credit card. While each brokerage is different, they all charge interest for the amount purchased on margin. The longer you hold the security on margin, the more interest you pay. This can seem like a nominal fee if the stock is rising, but can also seem like an enhanced loss if the stock is falling. Investors must allow for interest payments, usually taken monthly, when calculating margin purchasing power.
If the stock increases, the amount of margin purchasing power also rises by a factor of two to one. This is because the cash value of the account has risen. However, the increased value of the account is not secure until you sell the stock to lock in your gain.
If the stock value decreases, your margin purchasing power also decreases by a factor of one to two. For every dollar of value you lose, you can have $2 less purchased on margin. If you drop below the threshold of 50 percent, the brokerage can enact a margin call on your account. This means you must deposit the balance so that the account value raises back to 50 percent, or the brokerage house will sell the stock so you meet the requirement. Time allowed to deposit the funds varies by brokerage.
- stock image by Michael Shake from Fotolia.com