If you've ever heard an investor say that he's invested "on margin," read on to learn just what he means. And then think twice before doing the same thing.
Using margin means borrowing money from your brokerage, usually to buy additional stocks. For that privilege, you pay interest, just like with other loans. If the market turns against you, you either sell for a loss -- plus interest costs -- or hold on until the market picks up, paying interest all the while. If you're borrowing on margin and paying 9% interest, you should be pretty confident your stocks will appreciate more than 9%.
When margined securities fall below a certain level, the borrower will receive a "margin call," requiring an infusion of additional cash. If she can't raise the cash, the brokerage will sell some of her holdings to generate the needed funds. This can sting, possibly resulting in short-term capital gains taxed at high rates.
Margin amplifies your investment performance. As an example, imagine that you hold $100,000 of stocks and you margin that to the max, borrowing $100,000 to invest in additional stock. If your holdings double in value, you'll have earned an extra $100,000 (less interest expense) thanks to margin. But, if your $200,000 holdings drop by 50%, they'll be worth $100,000 and you'll still owe $100,000 (plus interest). That will leave you with. nothing. Your holdings dropped by 50%, but margin amplified that to a total loss. Margin cuts both ways.
On the Fool's discussion boards, one of our most read and recommended posts is from a reader named "globalstreamer," detailing how he lost his entire portfolio, $60,000, in two weeks -- by getting carried away with margin.
Only experienced investors should use margin. Although you're currently allowed to borrow up to 50% of what your actual holdings are worth, it's smart to limit yourself to no more than around 20%, if you borrow on margin at all. Many highly successful investors never use margin, so don't think that it's a necessary tool for you.