Leverage is often spoken of concerning the real estate market, but stock market leveraging is a practice often used by investors. The basic concept of leverage in the stock market, also called margin trading, involves borrowing capital to invest in more stock than what you can afford on your own. Stock market leverage can result in an increase in your return on investment, but you can lose more money than when buying stock using only your funds.
How Trading on Margin Works
Trading stock using margin starts with opening a margin account with your brokerage firm. This type of account differs from a regular cash account that you open with a financial institution. You must pay a deposit that acts as your margin, or initial equity in the account. Brokerage firms typically require an initial deposit of at least $2,000. In most cases, you can borrow up to 50 percent of your margin to invest in financial securities. You must also pay interest and fees for borrowing money.
After the purchase of the stock, you must keep a minimum amount of equity in your margin account. According to the Securities and Exchange Commission, you must maintain at least 25 percent of the value of your purchased equities in your margin account at all times. If the value of your securities drops substantially, the brokerage firm can issue a margin call, requiring that you repay all or a portion of your loan.
According to the Securities and Exchange Commission, the Federal Reserve Board, FINRA, the New York Stock Exchange and other self-regulatory exchanges determine the specific rules established to govern stock market leverage. Brokerage firms often establish their own rules regarding margin accounts. In the case of a margin call, the brokerage firm does not need your permission to sell a portion of the financial securities in your account. You also do not get to decide which assets the firm sells.
Stock market leverage offers investors the potential to earn a higher return on their investment because they are able to buy more shares than with using their own money alone. For example, if you buy a share of stock priced at $100 using your own money and the price increases to $150, you earn a 50 percent return on your investment. In contrast, if you use stock market leverage and buy the same stock on margin using $50 of your own money and borrow the other $50, your return is 100 percent if the stock price increases to $150.
The primary risk associated with margin trading is the ability to lose a substantial amount of money in a short period of time. The fact that you borrowed money to invest in stock results in the possibility of losing more money than you personally put up to buy shares. The sale of assets in your account by the brokerage firm can result in additional losses. Understanding the margin agreement given to you by your broker and the rules of margin trading can help minimize risk.
Video of the Day
- Jupiterimages/BananaStock/Getty Images