What does it mean to buy stocks on margin?

The price of stocks, especially when purchasing large amounts, can amount to tens of thousands of dollars. That's why some investors opt to purchase stocks on margin. Buying stocks on margin allows investors to pay for a fraction of the stock (usually around 50%, but it cannot exceed this), and then borrow the rest from their broker. Also referred to as leveraging, buying stocks on margin can result in a large return when the stock goes up. However, if the stock goes down, the investor stands the chance of owing more than he or she initially borrowed.

In order to buy stocks on margin, there are a certain number of things to keep in mind. First of all, certain stocks can't be bought on margin. For example, any stock that is less than $5 a share (also called penny or micro-cap stocks) cannot be purchased on margin. In addition, IPOs (Initial Public Offerings, or companies that have recently gone public) also can't be purchased on margin until they've been on the market a certain amount of time.

How Does It Work?
If you plan on buying stocks on margin, your broker will set you up with a margin account. Let's say you put $5,000 in it. That gives you $10,000 of buying power, since you can borrow up to 50%. If you decided to spend $4,000 on a certain stock, that would leave you with $6,000 worth of buying power - $1,000 in cash and $5,000 in your margin account (excluding commissions). The money isn't borrowed until the cash is gone.

What Are the Risks?
There are a certain number of risks involved with buying stocks on margin:
You could end up owing more than your initial investment. If the stock goes up and you make a profit, great. But if it falls below 75% of its original value, the broker will issue what is referred to as a margin call since the investor must have at least 35-55% equity in his account at all times. A margin call mean the investor much put more money into the account. If he can't do this, however, he'll have to sell the stock, pay the broker the amount owed, which might even be more once commissions are figured in.
It requires a good deal of knowledge about marginable stocks. Let's go back to the $5,000 example. The investor decides to purchase stock with his margin account that is worth $6,000. However, he does so without realizing the stocks purchased were not marginable, so he is $1,000 in debt (as he can't dip into his margin account). If this is the case, the investor will get a Fed call from his broker, telling him he has three days to put enough money to cover it into his account.

However, there are also a number of advantages to purchasing stocks on margin. For example, it gives you leverage by allowing you to purchase more stocks by using your assets you already have as collateral for the loan, and it also lets you to react quickly to new investment opportunities because you have the added money in your account. But like anything in investing, it's important to do enough research and discuss the pros and cons with your broker before deciding to buy on margin.