It sounds so sophisticated when dropped casually in cocktail-party conversation: "Oh darling, I bought shares of that company on margin in my brokerage account."
Only you know better. When you buy on margin, you simply borrow money from your broker to buy stock, using the cash and securities in your account as collateral for a line of credit.
It sounds oh-so-simple, but you know the pitfalls, which you share with your conversation partner when prodded. "Not all stocks are marginable (that is, able to be purchased on margin). Stocks under $5 a share as well as IPOs (for a certain period after their debut) can't be bought that way," you say in a nonchalant manner as you sip your martini and scan the room. "Occasionally, you'll find that you are unable to purchase other Nasdaq stocks on margin. And, of course, most brokers require that you meet their account minimum. But please, I don't want to bore you with such pedestrian details."
Other party guests are now gathering to listen in, nodding as if they're already in the know, yet hanging on your every word.
You share this example: Let's say you have $10,000 in your account. That $10,000 in your margin account provides you with $20,000 in buying power. (You must put up 50% of the purchase price of the stock you wish to buy.)
You decide to dabble a bit in the market and buy a stock with $8,000, which leaves you with $12,000 in buying power (ignoring commissions, for the sake of simplicity) -- that's $2,000 in cash and $10,000 that you can borrow from the broker. You don't actually borrow the money until you run out of cash, but it's still there for you to use.
The dreaded margin call
The lights drop and the five-disc CD player finds a dark piano concerto right on cue. You relay the story of a dear, dear friend who jetted off to the islands for tax-free head-to-toe lipo, forgetting his financial affairs. Suddenly, out of touch and under heavy sedation, the share prices of his margin positions deflated.
He was rustled out of his unnatural slumber by an incessant ringing -- his broker frantically trying to get through.
He learned the hard way that brokers require that the equity in a margin account (that's the market value of the securities minus the amount you owe the broker) remain above a certain percentage. The fall in your lithe friend's marginable positions dipped below his broker's required percentage. And he found himself on the ugly side of that dreaded maintenance -- or margin -- call.
Cough up the cash
Not one to dwell on others' misfortunes, you share with your riveted companions the secret to getting out of such a pickle. You tell them that the broker will ask for additional funds to bring the account equity back above the minimum level (it can range from 35% to 50%, depending on the broker). To do so, investors can simply send in more money or close one or more positions in their account.
A friend arrives and you slowly begin to move her way. "If you choose to buy on margin, remember that the buying power of your account can change daily as the share prices of marginable securities in your account fluctuate," you say in your sing-songy way as you excuse yourself to go greet her with an air kiss.