Page 134

of your own cash in your account, your broker may allow you to buy $2,000 worth of stocks. The extra $1,000 is a credit from your broker and it works just like a regular loan. If you decide to use it you would be paying interest on it just like a loan from a bank or a credit card. What is important to understand is that the amount of margin is calculated based on your equity, not just your cash. Your equity equals your cash in your account plus other stock holdings you may have in your account that you bought with your own money. For example, if you use your initial $1,000 to buy a certain stock, your cash value in your account will be $0 now but your equity is still $1,000 since you can sell your stock at any time and return to your $1,000 cash position (barring any changes in the stock price in the meantime). So the broker in our example still allows you to borrow $1,000 against the value of your stock holdings, which means you could buy another $1,000 worth of stocks.

This would be a good time to cover the concept of equity. Equity is an important notion when it comes to stocks. In fact you may have heard people sometimes use the words stock and equity interchangeably, and the stock market is referred to as the equity market at times. Equity really means value or assets, and stocks certainly have value. For example, if a creditor (such as a mortgage company) is asking for your equity, your stock holdings would be a part of your equity or your net worth. Also since you can sell your stocks at a moment’s notice and access their cash value, they can be considered as liquid equity. Liquid in this context would mean an asset that can be easily converted to cash.

Buying on margin, however, is not as simple as it seems. First of all, as I explained, you need to look at margin as a loan which comes with its own set of obligations. Just as any loan, buying on margin puts you in debt, and just like any other loan, you would be responsible for …