Two fundamental concepts that be applied to investing are the concepts of leverage and margin.
Margin refers to a loan that a broker provides to give an investor the opportunity to enter larger trades. Like any loan, this loan isn’t free – the securities and money in the investor’s margin account act as collateral and the principal of the loan must be repaid with interest.
The reason investors want margin is to create what is known as leverage.
Leverage allows an investor to increase one’s buying power, consequently allowing him or her to pay less than full price for a trade. This leverage is usually expressed in the form of a ratio. For example, 2:1 ratio would be being able to purchase $10,000 of stock when you only have $5000 in your account.
Combining margin and leverage usually results in a high risk, high reward situation. If a stock is bought using leverage, higher returns can be the realized, but if the stock goes down the consequences can be dire.
