Margin purchases are share transactions that are supported by a loan. In this trade process, you borrow money to create margin purchases. Your credit must qualify you for the loan. These trades cannot be purely financed, since all margin investors must post 25% of the trade at minimum. The rest is borrowed from the broker. The amount paid in equals the initial margin. The broker will then loan the money at a set rate, and add a service charge. Any securities purchased with the loaned money are used as collateral for the loans.
The broker sets a limit, called the maintenance margin. The maintenance margin is (generally) equal to the percentage of money that must be paid in by the investor. If the value of the investment falls below this limit, you will be required to add more money to the trade. The broker will notify you to increase the amount of money invested via a “Margin Call”. You will have a limited amount of time to add this money to the account. If you do not post the margin, shares will be seized and sold to balance the trade, and you will not be reimbursed for their value.
Margin purchases increases the downside risk, but also increase the return of investments. If you borrow 50% of the money for an investment, post 50% of your own money, and the investment increases 10%, you will receive a 20% total return. If you had invested all of the money yourself, you would have received a 10% total increase. If the shares decrease, you have to pay for both the loans and suffer lost capital. Investors generally must be extremely optimistic to purchase on margin.
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