Buying stocks on margin has been especially popular among investors who have seen the price of shares they own increase sharply and who want to take advantage of those profits without selling their stock.
For example, someone who bought 100 shares of stock at $100 a share and then saw that stock double in price would have $10,000 in profits that could be used as collateral for further purchases. Without risking the initial investment, he could use the $10,000 profit as a margin deposit and buy an additional $20,000 worth of stock without putting up cash.
A more aggressive margin buyer might buy the first $10,000 worth of stock on margin, putting up only $5,000 cash. If the price then doubled, the account would have $15,000 in equity -- the initial $5,000 plus the $10,000 profits. The $15,000 equity could be used as margin on $30,000 worth of stocks, purchased with only $5,000 in cash.
But just as margin buying leverages investors' profits when prices are rising, it tilts the table sharply against them when prices begin to fall. Losses wipe out the investors' equity first, leaving margin calls to be met and margin loans to be repaid -- as many investors have learned in the last two weeks.
Take the example of the investor who bought 100 shares at $100 with a $5,000 down payment, and decided to leverage the investment still further after the stock doubled in price to $200 a share. Before the market crash, this hypothetical investor held $30,000 worth of stock -- 150 shares at $200 apiece. Only $5,000 cash was in the brokerage account, another $10,000 was the equity resulting from the initial price run-up and the remaining $15,000 was margin debt.
When the market collapsed Oct. 19, the stock dove to $125 a share, reducing its value to $18,750. That night, the broker was on the phone with a margin call.
After deducting the $15,000 borrowed from the broker, the day's plunge had left the investor with only $3,750 equity in the account. (The Federal Reserve's 50 percent margin requirement only applies to the initial purchase of stock. After that, "maintenance margin" requirements are set by stock exchanges and brokerage houses. Though most brokers require 30 percent maintenance margin or more, the minimum permitted by exchanges is 25 percent.)
In this case, the customer falls short; 25 percent of the value of the stock after the crash would be $4,687.50. The customer has three days to come up with another $937.50 or the broker will sell enough stock to meet the margin call.
Selling stock to meet margin calls can be very costly, because it is heavily mortgaged. When a customer's margin has dropped to the 25 percent minimum, three quarters of the value of each share belongs to the broker.
Here's what happens: The customer owns 100 shares worth $100 a share for a $10,000 investment, but losses have driven the equity down to the 25 percent minimum. When the shares are sold, the broker takes the first $7,500 to pay off the margin loan, leaving the customer only $2,500 to bail out other stocks.