Buying on margin is an investing strategy in which you borrow money from your broker or bank to buy stocks, bonds, options, or other securities. The idea is that with more money at your disposal, you can buy more stock, helping you to potentially increase your gains. Yet, as you might expect, with higher rewards come much higher risks: you could very likely lose more money than you’re willing to stomach.
What exactly is buying on margin, how can you start, and what are the risks? Below we’ll break down this high-risk trading technique and see if it’s right for you.
What is buying on margin?
Buying on margin is simply using borrowed money to buy more stock than you would otherwise be able to do.
In financial lingo, “margin” refers to what you must deposit with a broker in order to conduct margin trades. Think of margin as a security deposit. In order to borrow money from your broker, you need to put some skin in the game, so to speak. For instance, your broker may require you to put 50% of margin in your account. If you wanted to buy $10,000 of stock, you would have to put $5,000 in your margin account in order for your broker to feel comfortable lending you the other $5,000.
As an investor, $10,000 may sound far more lucrative than $5,000. But here’s the thing: the stocks you buy with that $10,000 serve as collateral for your $5,000 loan. If your entire holding drops by $5,000, your broker may force you to sell your shares and pay them back. As you can imagine, this is why buying on a margin is a risky strategy, as you could easily lose double what you invested.
What is an example of buying on margin?
Let’s say you have $5,000 in cash, and you want to buy $10,000 of Stock Y, which trades at $50 per share. You’re confident the stock will go up, so you open a margin account (more on this later), deposit your $5,000, borrow $5,000 from your broker, and buy 200 shares of Stock Y.
During the first week, your prediction comes true. The price of Stock Y goes from $50 to $62.50 per share, which is a 25% increase in the original share price. Your holding of Stock Y is now worth $12,500. Of course, the actual value of your holding is $5,000 less, since you still owe money to your broker. If you sold your stocks and paid back your broker before Stock Y’s price moved again, you would walk away with a nice $2,500 gain.
But let’s say you don’t walk away. Let’s say greed gets the best of you and you wait another week. Unfortunately, the Stock Y company released its Q3 earnings, which are far below what everyone was expecting. The price of Stock Y falls from $62.50 to $37.50. Now, your 200 shares are worth $7,500. If your broker forced you to sell at this point, you’d walk away with $2,500, just half of what you started with.
How do you start buying on margin?
In order to start buying on margin, you have to open a margin account with a brokerage. Not all brokers offer margin accounts, so you’ll have to double-check with your broker if they do.
If your broker does allow margin trading, you’ll typically have to fill out a fairly lengthy application to open an account. Your broker will most likely check your credit, too, since they want to be sure you’re a responsible borrower. You’ll also need to sign a consent form saying you understand the risks of margin trading, and you’ll pay back what you borrow.
Once you’re approved, you’ll have to deposit a minimum margin (sometimes called the “maintenance margin”). This is the absolute minimum you must have in your margin account at any given time. If your account goes below this minimum, your broker will issue a margin call, requiring you to add funds or sell your investments.
If all goes well and you have a margin account, you’ll want to learn your borrowing limitations. Your broker may place a cap on how much they lend you, or they may not allow you to buy every stock within your margin account. You’ll also want to figure out how much interest your broker will charge you for buying on margin, as this can significantly eat into your gains if you’re not careful.
What are the pros of buying on margin?
Perhaps the greatest benefit to buying on margin is its ability to boost your buying power. With most margin accounts, you can borrow up to 70% of a security’s price, at the very least 50% (Canada has different requirements for different stocks). For a stock that’s going for $50 a share, you can borrow $25 to $35 a pop, allowing you to buy more shares than you normally would.
It’s important to note that margin trading is most effective when done for short-term gains. The shorteryou hold on to stocks bought on margin, the less interest you’ll pay to your broker. Conversely if you hold on to your stocks for longer periods of time, you’ll get stuck paying high interest charges.
What are the risks?
Before you get your hopes up, we’ll be straightforward with you. Buying on margin is extremely hard to do well, let alone do enough to make extraordinary gains. In fact, when you factor in money lost to interest, the odds of getting rich are fairly low.
Before you open a margin account, here are some common risks you should be aware of.
1.Major losses
Whenever you invest in securities, whether stocks, bonds, or even cryptocurrency, you also run the risk of losing money. But with traditional stock investing you can only lose what you initially invest — and never more. If your stock’s company goes bankrupt, your holding will go to zero. But under no circumstance will your broker ask you to pay more than what you invested.
With margin trading you can lose more than you originally invested. Let’s take our example from above: you invest $5,000 of your own money in Stock Y, along with $5,000 borrowed from your broker, for a total of $10,000. All it takes is a 50% hit on Stock Y’s value, and you instantly lose 100% of your original investment ($5,000). On top of that, you still have to pay your broker the remaining $5,000. Factor in interest rates and fees, and you can see how margin trading can result in major losses.
2. Margin calls
Recall that every margin account has a built-in minimum called the maintenance margin. At any given time, your margin account must have at least the maintenance, and no — that doesn’t include the money you borrowed from your broker.
When your margin account falls below the minimum threshold, your broker will issue a margin call. This call forces you to add more funds to your account or sell some of your investments to cover the difference.
For example, let’s say you buy shares of Stock Y with $5,000 of your own money and $5,000 on the margin. Let’s also say your account has a maintenance margin of $2,000. If the value of your Stock Y holding falls by 31%, you’d be left with $6,900. Your broker will always subtract the borrowed amount by the value of your holding to decide if you still meet the minimum. In this case, you’re below the minimum ($6,900 – $5,000), and your broker will issue a margin call.
As you can see, this is where the margin game gets serious. If you add more funds, and Stock Y continues to fall, you’ll lose more money. On top of that, you still have to pay your broker back.
3. Interest
When you buy on margin, you’re essentially taking out a loan through your brokerage. And, like other loans, you’ll pay an interest rate for every day you don’t pay your loan back.
The exact interest rates on margin trades depends on the brokerage. Occasionally, brokers will give you lower interest rates if you trade at high volume. But don’t expect a favor — interest rates on margin trading aren’t typically generous.
The biggest risk with interest rates is that they will cut your gains by a significant amount. If your broker charges an 8% margin interest rate on $5,000, for instance, you’ll pay $400 each day. Unless you make more than that on your first day, the interest charges could easily outweigh the gains.
Should you buy on margin?
First off, if you’re a beginning investor, you should think twice before engaging in margin trading. Spend some time learning the basics of investing, such as how to judge good quality stocks as well as how to diversify your portfolio, before you graduate to more advanced techniques.
If you think you’re up for the challenge, take a step back and gauge your risk tolerance. Buying on margin is an extremely risky investing strategy, and it’s done well in the hands of someone who doesn’t react strongly to market volatility. If your risk tolerance is moderate or low, it might not be right for you.
You should also have a significant amount of money to play with. If you have a well-rounded investment portfolio, with holdings in numerous companies across different sectors and countries, and you think you’re set to retire the way you want, you may want to try your hand at margin trading. On other hand, if you’re thinking about using a significant portion of your investment money as collateral in a margin account, you could be setting yourself up for a hard loss.