There’s an old Chinese saying: “Water can float a boat as well as sink a boat.”

The idea that the same thing can be both helpful and harmful often applies in life. It does, too, in the world of investing.

For example, most people would think of risk as a bad thing, but “risk” itself only refers to volatility and uncertainty. Downside risk is bad, but upside risk is good. Without risk, you wouldn’t be able to earn much return from your investments. Just look at Treasury yields, which when adjusted for inflation are actually negative!

Surely, the dream scenario for an investor would be to invest in something that has essentially no risk but offers a big return. Unfortunately, in reality, there will be a trade off between risk and reward.

Related to risk is the use of margin, which can amplify your gains but if things go wrong, amplify your losses.

How Margin Works

When you open a brokerage account, you can decide to make it a margin account. And even if you’ve already opened a cash account, you can still apply to change it to a margin account. You won’t be able to trade on margin in a retirement account such as an Individual Retirement Account (IRA), because the IRS doesn’t allow it.

With a margin account, you can borrow cash from the broker to buy stocks, increasing your purchasing power.

Read This Story: The Power of Investment Leverage

If you have $50,000 in a cash account, $50,000 is the most you can invest.

In a margin account, you are limited to borrowing up to 50% of the purchase amount. But this means your purchasing power is essentially doubled (ignoring any commission and fees), which makes a big difference. If you have $50,000 and borrow $50,000, the total purchasing power is $100,000. $50,000, or half, of the $100,000 is your own money, so that satisfies the requirement.

After the initial purchase, you will have a maintenance requirement. Your equity (what you put up) must be no less than 25% of the value of the security. If your equity in the account falls too low, you’ll be subject to a margin call.

Note that the 50% initial margin and 25% maintenance margin are minimums set by The Financial Industry Regulatory Authority (FINRA). In practice, your broker may have higher requirements.

The Good and the Bad

Let’s say you buy only one stock for your portfolio, at $100 per share. In a cash account, you can buy 500 shares. In a margin account, you can buy 1,000 shares. If you sell the stock later for $120, you would make $10,000 ($20 per share x 500 shares) in the cash account but double that in the margin account. Thus, with only $50,000 of your own cash, you made $20,000, a 40% return on your money.

If the stock falls enough to trigger a margin call, however, you’ll need to increase your equity in the account. You can do this by depositing more cash, selling stock, or transferring in stock that increases your equity. If you fail to do enough, the broker will forcibly sell securities in your portfolio until you meet the maintenance requirement. This can result in you selling the stock low and missing out if the stock rebounds later.

Let’s continue with the example of the portfolio that only has the $100 stock, purchased fully on margin.

The formula to calculate the margin call price for the stock is: initial purchase price x (1 – initial margin percentage) / (1 – maintenance margin percentage)​.

Thus, if you buy a stock for $100, and the initial and maintenance margin requirements are, respectively, 50% and 25%, the margin call price would be: $100 x (1 – 0.5) / (1 – 0.25) = $66.67 per share.

Think of it this way, originally you borrowed $50 to buy the $100 stock. Once it drops to $66.67, you still owe $50, so only $16.67 of the $66.67 stock is your own money. And $16.67 / $66.67 is 25%.

Additionally, the broker isn’t lending you money out of the goodness in their heart. You pay interest on the money you borrow. So if the trade goes against you, you not only lose on the trade, but you have to pay interest on the borrowed amount as well.

Trading on margin is risky and isn’t for everyone. If you have low risk tolerance, you’ll want to avoid it. But if you’re seeking to aggressively increase your wealth and don’t mind taking on higher risk, it may be for you. And of course, you don’t necessarily have to use margin to increase the upside potential of your portfolio.

Meanwhile, to guide you through these perilous times, our analysts have compiled a special report of seven shocking investment predictions for 2022, and how to profit from them. To download your free copy, click here.