Final answer:
Buying stocks on margin comes with risks, including the potential for losses if the stock price decreases and the possibility of margin calls. If the stock value falls below the amount borrowed, the investor may have to repay the loan with their own funds, resulting in a loss of equity. Additionally, if the stock falls below a certain threshold, the broker may require additional funds to maintain the margin requirement.
Step-by-step explanation:
Buying a stock on margin refers to the practice of borrowing money from a broker to purchase stocks. While it can be a way to increase investment potential, it also comes with risks. One problem that may arise from buying a stock on margin is the potential for losses if the stock price decreases. If the value of the stock falls below the amount borrowed, the investor may have to repay the loan with their own funds, resulting in a loss of equity.
For example, let's say an investor uses $5,000 of their own money and borrows another $5,000 from a broker to purchase $10,000 worth of stock. If the stock price drops by 20%, the value of the stock would decrease to $8,000. However, the investor still owes the broker $5,000, which means they would have lost $3,000 of their own money.
Another problem is the potential for margin calls. If the value of the stock purchased on margin falls below a certain threshold, the broker may require the investor to deposit additional funds to maintain the margin requirement. Failure to do so could lead to the broker liquidating the stock to cover the loan.