source : investopedia.com
Why is purchasing stocks on margin considered more risky than traditional investing?
Buying on margin involves borrowing money from a broker to purchase stock. A margin account increases your purchasing power and allows you to use someone else’s money to increase financial leverage. Margin trading confers a higher profit potential than traditional trading but also greater risks. Purchasing stocks 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 front more capital to keep your investment.
Suppose you have ,000 in your margin account, but you want to buy stock that costs more than that. The Federal Reserve has a 50% initial margin requirement, meaning you must front at least half the cash for a stock purchase. This requirement gives you the ability to purchase up to ,000 worth of stock, effectively doubling your purchasing power.
After you make the purchase, you own ,000 in stock and you owe your broker ,000. The value of the stock serves as collateral for the loan he has given you. If the stock price increases to ,000 and you sell it, you keep what remains after paying back your broker (plus interest). Your proceeds equal ,000 (minus interest charges) for a 100% gain on your initial investment of ,000. Had you initially paid for the entire ,000 yourself and sold at ,000, your gain is only 50%. This scenario illustrates how the leverage conferred by purchasing on margin amplifies gains.
Leverage amplifies losses in the same way. Suppose the stock price decreases to ,000 and you sell it to prevent further losses. After paying your broker the ,000 you owe him, your proceeds come to ,000. You lost half your original investment. With traditional investing, however, a price drop from ,000 to ,000 only represents a 25% loss.
Another risk of purchasing stocks on margin is the dreaded margin call. In addition to the 50% initial margin requirement, the Financial Industry Regulatory Authority (FINRA) requires a maintenance margin of 25%. You must have 25% equity in your margin stocks at all times. Your margin agreement with your broker may call for a higher maintenance margin than FINRA’s minimum. If the value of your stock decreases and causes your equity to fall below the level required by FINRA or your broker, you may receive a margin call, which requires you to increase equity by liquidating stock or contributing more cash to your account.
Returning to the example above, assume your broker’s maintenance margin requirement is 40%. Because you owe your broker ,000, a drop in the stock price from ,000 to ,000 decreases your equity to ,000. That is only 33% of the stock price – you have fallen below the 40% minimum. If you cannot or choose not to contribute more capital to cover the margin call, your broker is entitled to sell your stock, and he does not need your consent.
How risky is it to buy stocks on margin? – Quora – Greetings, Know the risks associated with buying stock on margins BEFORE you begin: The Stock Falls Drastically The Stock Price Doesn't Change Buying stock on margin costs you money even if the stock price doesn't change. Why is short-selling considered more risky than buying stocks?This is why margin investing is usually best restricted to professionals such as managers of mutual funds and hedge funds. Of course, if an investment purchased on margin does well, the gains can be richly rewarding. Besides using a margin loan to buy more stock than investors have cash for in a…The main reason why stock bought on margin was considered a risky investment was because "Investors purchased the stocks with little cash down; if the price dropped the investor had to repay the loan," since this meant that they borrowed most of the money from a bank or other lender.
Buying On Margin: Costs, Risks And Rewards | Bankrate.com – If you have been investing for a while, you have undoubtedly considered buying stock on margin. And why not! Your broker offers margin investing (what As you can see, playing on margin can be risky should your stocks decline significantly. If you do use margin at some point, keep it conservative.Not all stocks can be bought using a margin account. The stock exchange regulatory board doesn't let you buy securities like Initial Public Offerings It is risky business, as you may end up in serious debt if your stock does not perform as well as expected. Only experienced and seasoned investors…There were so many people buying on margin that a lot of companies stopped investing in their own business and sent all their cash to Wall Street to support margin loans because high True or False: Big Banks were given Trillions of dollars lately…and that is why the stock market just keeps going up?
Why was stock bought on margin considered a risky investment? – Stocks are certificates of ownership. A person who buys stock in a company becomes one of the Bonds generally pay more money than preferred stocks do, and they are usually considered a safer Buying on margin is very risky because the loan must be repaid to the broker, with interest…Why was stock bought on margin considered a risky investment? Investors purchased the stocks with little cash down; if the price dropped the investor had to repay the loan. What happened when the Federal Reserve limited the money supply?…not entirely clear offhand why buying stocks using stocks as collateral is "risky", but buying stocks and using your home as collateral is less risky!? be duplicating the effect by buying stocks on margin or "on mortgage" by keeping a giant mortgage outstanding while investing in the portfolio at…