Stock Market Leverage: The Pros and Cons of Mr Margin

When investing in the stock market, you have the option of opening a cash account or a margin account.

A cash account is one that pays for your stock purchases in full with cash. A margin account allows you to buy stocks with money borrowed from the broker you are trading with. This has a cost, advantages, disadvantages, and horrible consequences.

The advantage of buying stocks on margin is leverage. Under current rules and regulations, investors can earn a 50% margin. This means 2 to 1 leverage. For every dollar of upward movement of stocks, you would double your profit.

However, leverage can be a double-edged sword. For every dollar moving down in stocks, your loss would double as well. Suppose you borrow 50% of the stock purchases and the stock price is cut in half in a crash, you will get in touch with a rather unpleasant message.

You will be asked to put more cash into the account to carry the stock. If you do not do so before the deadline, usually within 3 days, your account will be liquidated. The broker will sell his shares on the open market to redeem his margin, the money he borrowed from him. This is not discounted if several days later stocks recover and begin to rise again.

During the roaring 1920s, the margin requirement was very flexible. Investors leaned against the hills. Some borrowed up to 90% of the value of the shares, much like the current real estate speculation. The market was overheated and the bubble burst without any financial strength for the company.

They all wanted to make a quick buck. When the market finally turned south, panic selling settled in. Most investors were unable to bring in cash and margin calls are echoed throughout the market. And this ignited the Great Depression of the 1930s.