When you open an account with the brokerage firm, they would usually give you a choice of opening a cash account or a margin account. A margin account is simply an account where the company will finance a portion of the stock you purchase, depending on which stock it is.

The advantage of this to the client is that they are allowed to buy more stock. For example, if the particular stock purchased has a 70% margin financing, which means the company will finance up to 70% of the cost, then it would mean you would be able to buy almost 3 times as much stock as compared to when you didn't.

Of course, there has to be advantages for the company to do that. When you buy stocks using margin, it means you have to have money deposited first before you can buy any. This limits the risk for the company. Also, if you do ever make a bad trade, the company would be able to sell the other stocks you have, because they are holding it in their custody. (as compared to having it in CDP when you use a cash account)

When you use a margin account, stocks are typically labelled as class A, class B and class C. Usually class A would have 70% financing and consists of stable stocks such as the 'blue chips', class B consists  of most other stocks and it would have 50% financing, and class C consists of all the other stocks, typically the high risk penny stocks. The class C stocks have 0% financing.

So for example, if  you have $10,000 and you wanted to buy a stock that is worth $1. Simple maths would say you can buy 10,000 of the stocks using a cash account. (Excluding commissions)

Using a margin account and assuming it is a class A stock, you would be able to buy $10,000/1=10,000 * (1/1-0.7) = 33,333 of the stocks. So if the stock does go up, you would actually make 3.33 times more than if you bought it using the cash account. So what happens if the price of the stock drops?

In a cash account, you would be able to hold the stock forever. In a margin account however, there is this evil thing called margin requirement and margin calls.

The company calculates this number called the margin requirement by taking your current price of the stock, divided by the total amount loaned. So in this case, when the price is $1, the margin requirement is $33,333/23,333 = 142.8%

As long as the amount is above 140%, you do not have to do anything. Once it dips below 140%, the company will then expect you to deposit more cash until it becomes more than 140%, or that u voluntarily sell some stock, or they will sell your stock, even if you don't consent. Thus, the word "force sell".

Thats why, one should never use up their margin to the maximum. There should be some form of buffer cash in your account.

On another topic, we will talk about CFD, and how it provides 80% margin financing, as well as other advantages.

The other factor people tend to neglect is that, the financing by the company is not interest free! In fact, they tend to charge interest around the regions of 6-9% per annum. So, make sure you know what you are doing before you do margin trading.

In short,

Advantages: More leveraged, will make more money when you are winning, able to buy more stocks of different counters, brokers more willing to give you a higher trading limit.

Disadvantages: You lose more when the price drops, there is a risk that there will be force selling, hidden charges such as interests.

** The numbers may vary among the different margin accounts by different brokerage firms.

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