Buying on margin is a risky way to pump up the potential return on your investment. Margin trades involve borrowing money from your broker to purchase an investment. Let's run through an example of how buying on margin can be profitable and also how it can be a risky game:
Let's say you want to buy 100 shares of fictional company Illini Basketballs Inc. Each share costs $10, so your total cost would be $1,000 (we'll ignore commissions for now). If those shares go up to $12 after you buy, your return would be 20%, or $200 (100 shares x $2 per share profit).
Now let's say you bought those 100 shares on margin. Instead of using $1,000 of your own money, you borrow $500 and use only $500 of your own money. Now if the stock goes up to $12, your return jumps to 40% ($200 profit/$500 initial investment).
Of course nothing is free, so you'd have to pay interest on the $500 you borrowed. Nevertheless, it's easy to see how buying shares of a company on margin can really juice your returns. But below is an example of how buying on margin can turn ugly. We'll use the same example as above, but with a twist:
You've borrowed $500 and used $500 of your own money to buy 100 shares of Illini Basketballs Inc. at $10. If Illini's shares drop to $8, you've suddenly lost 40% of your investment, and you still owe your broker the $500 it lent you.
If stock bought on margin keeps going down, you might even eventually get a dreaded "margin call." This means your broker is getting nervous that you might not have enough money to pay back the loan. If you get a margin call, you'd have to contribute more cash to your account, or sell some of your stocks to reduce your loan. Typically, these sales happen at precisely the wrong time--when stocks are down and at bargain-basement prices. Brokerage houses usually have set requirements that dictate how much of your own cash you need to have in your portfolio when trading on margin. Buying on margin is not for beginners, so tread carefully.