In the same way that a bank can lend you money if you have equity in your home, a stock brokerage can lend you money against the value of certain investments in your portfolio. Generally speaking, you can borrow up to 50% of the purchase price of eligible investments. In other words, you may only be required to put up $5,000 of your own money in order to purchase $10,000 worth of stocks or bonds.
By doubling your purchasing power, you also double your potential returns. If your $10,000 investment grew to $15,000, you could sell the shares, pay back your $5,000 margin loan, and be left with a $5,000 profit, effectively doubling your money. Amplifying the power of your money in this fashion is known as using “leverage.”
However, the power of leverage works both ways. If your $10,000 investment were to decline by 50%, the broker could force you to sell your shares and you’d lose your entire original $5,000 investment, so there’s still no such thing as a free lunch.
