Margin trading is a special form of trading that involves borrowing money from a stockbroker to purchase shares. The investor then repays the money plus an interest fee at a later date. The shares serve as collateral in case the investor does not repay the money.
The main reason for using margin trading is to increase the potential profits without being limited by the lack of available cash. For example, if you invest $500 in a stock, it may take a significant rise in the price to make a decent amount of cash, especially if there are fixed transaction costs. If you use margin trading to invest $10,000 in the stock, it will only take a small rise in the price to make the same profit. Of course, margin trading also increases the potential for losses.
Standard Margin Requirements
A stockbroker who lends money to an investor protect himself against the investor's failure to repay and the potential for loss after selling the shares that serve as collateral. To minimize risk, the stockbroker requires the investor to put up extra cash if the stock price falls. This is known as maintaining the margin. Most margin trading in the U.S. is regulated by the Federal Reserve Board, the New York Stock Exchange or the National Association of Securities Dealers, according to the Securities and Exchange Commission. Generally you must put up the cash for at least half the total stock purchase, with the rest provided by the stockbroker on margin.
Another ongoing margin requirement is known as a maintenance requirement. The Financial Industry Regulatory Authority requires that at all times the investor's equity, which is the current market value of the stocks minus the amount the investor borrowed, must be at least 25 percent of the current market value of the stocks. If this is not the case, the investor can be forced to repay some of the borrowed money to rectify the shortfall.
Special Margin Requirements: Stockbrokers
Some stockbrokers have higher maintenance margin requirements -- often in the range of 30 to 40 percent. The effect is that it takes a smaller drop in the stock price before the investor's equity is too low and the investor is forced to put up extra cash.
Special Margin Requirements: Stocks
While stockbrokers have a standard margin requirement for customers, they may have a special higher margin requirement for particular stocks. Usually these are stocks with a history of volatility, meaning the price changes dramatically. These higher margin requirements mean it can only take a tiny drop in the stock price before the investor has to put up more cash. Note that the precise effects depends on how much money the investor puts up in the first place compared with how much he borrows.