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There are two ways to purchase stocks:
a) Tthe buyer can pay the purchase price in full
b) Using a margin account. In a margin account purchase, the buyer pays a portion of the purchase price and the broker lends the difference. The buyer in turn pays interest on the broker's loan in addition to the usual commission fees. For collateral, the broker holds onto the stocks. Dividends earned from the stocks are used to help offset the interest payments.
Margin is determined by the following equation:
It looks complicated, but it isn't. Here's an explanation:
M is the margin, V is the market value of the securities, and L is the broker's loan. The ratio is expressed as a percentage. The lowest initial margin, or the margin at the time of the purchase, is 50% (as set by the Federal Reserve Board). After the purchase of the stock on margin, there is a maintenance margin below which the margin is not allowed to fall. On the New York Stock Exchange, the maintenance margin is 25%, but brokers can set their own margins (30% is common). If the margin falls below the maintenance margin, the broker calls for additional cash from the investor. If the money does not come within the specified time, the broker immediately sells the stock.
Buying on margin is a technique that many investors use. It allows better utilization of available resources. But as the investor, you must be completely aware and positive about buying before you actually do so.
When you trade on margin, you can gain buying
power by borrowing a major portion of the investment amount.
If you initiate a short sale on margin but the stock is not available to borrow, your account will be subject to a mandatory "buy in" for all or part of your short position.
In the event of a recent purchase or market fluctuation, there may be additional equity required in your margin account.
Usually a check or securities must be recieved by the due date noted in the margin call letter. If the margin call is not met by the due date, securities could be liquidated from your account to meet call requirements.