Let us say someone told you to buy stocks on margin. Do you really know what it means ? Do you need to know about margin trading ? Do you really understand margin trading ? Do you understand all the pros and cons of margin trading ? If you have answered No to anyone of them, it is time you understand one of the most powerful investment tool in the stock market.
Buying stocks on margin is nothing but buying stocks by borrowing money from your broker. Think of it as a loan given to you by your broker. Why would you want to borrow money from your broker ? Obviously to buy more stocks. Generally novice investors begin with a cash account which only uses the money deposited in their account. For margin trading you need to open a margin account, which can be opened during the time of opening a cash account. Margin account generally requires a minimum deposit of $2,000. Once the margin account is opened you can borrow upto 50% of the purchase price of a stock from your broker. However you can borrow less than 50% if you wish to.
Restrictions on the Loan
You can keep your loan as long as you want, provided you follow few restrictions.
- When you sell the stock in a margin account, the money has to be first used to repay the loan.
- There is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay your loan. This is known as a margin call.
- When you borrow money from the broker, you also have to pay the interest on it.
Example on Margin Trading
Let’s say that you deposit $10,000 in your margin account. This means you can borrow another 50% (i.e. $10,000). This brings your total buying power
to $20,000. Say you buy stocks worth $5,000. In that case you have the option of either using your cash account
and pay the full amount of $5,000 for the stocks or use the margin account
and borrow the $2,500 from the broker. If paid from the cash account, you do not have any obligation to the broker. However if you paid from the margin account, you definitely have to follow the above listed restrictions.
Now instead of $5,000, let us say you purchase stocks worth $20,000. In that case you would be using your margin account and borrowing $10,000 from your brokerage and paying $10,000 yourself. If the value of the stocks drop to $15,000, the money in your account falls to $5,000 (ie. $15,000 – $10,000 = $5,000). Assuming that the maintenance margin (minimum account balance) is 25%, you must have $3,750 in equity in your account (25% of $15,000 = $3,750). Thus, you’re fine in this situation as the $5,000 worth of equity in your account is greater than the maintenance margin of $3,750. But let us assume the value of the stocks drop to $12,000, leaving your money in the account to $2,000 (ie. $12,000 – $10,000 = $2,000). In this case, your money is less than the maintenance margin. As a result, the brokerage may issue you a margin call. If for any reason you cannot meet a margin call, the brokerage has the right to sell your stocks to increase your account equity until you are above the maintenance margin. Additional your broker may not be required to consult you before selling and can sell stocks you did not intend to sell.
Power of Leverage
Savvy investors use the power of leverage for higher rewards. Margin trading provides the facility to trade stocks based on leverage. However leverage has the power of amplifying your gains as well as losses. This can be explained easily by the following 2 examples.
Example on Power of Leverage – Amplify Gain
Going back to the previous example, say you bought stocks worth $20,000. In that case you would be borrowing $10,000 from your brokerage and paying $10,000 yourself. Let us also assume that the price of each stock you bought is $100. Had you bought the stocks only using your money, you would end up buying 100 shares (ie. $10,000/$100 = 100 shares). Since you are buying on margin, you have the ability to buy 200 shares ($20,000/$100 = 200 shares). In one month due to solid earning, say the stock price jumped to $125 (a 25% price increase). Your investment is now worth $25,000 (200 shares x $125) and you decide to cash out. After paying back your broker the $10,000 you originally borrowed, you get $15,000 back with a net profit of $5,000. That’s a 50% return even though the stock went up only 25%. If you minus the broker commission and interest for borrowing the money, you still end up getting 45% return. This is definitely better than 25% you would have gained had you not used margin account.
Example on Power of Leverage – Amplify Loss
Say that instead of rocketing up 25%, our shares fell 25%. Now your investment would be worth $15,000 (200 shares x $75). You sell the stock, pay back your broker the $10,000, and end up with $5,000. That’s a 50% loss, plus commissions and interest, which otherwise would have been a loss of only 25%. So as you see, the power of leverage can work both ways.
Pros of Margin Trading
Leverage: Provides the power of leverage. Investors can borrow money and leverage the cash they invest. If you pick the right investment, margin can dramatically increase your profit.
Buying Power: A 50% initial margin allows you to buy up to twice as much stock as you could with just the cash in your account.
Amplify Returns: With twice the buying power, margin does offer the opportunity to amplify your returns.
Flexibility: Money obtained from the stocks sold through the cash account has to wait 3 business days to clear. This does not apply to margin accounts.
Cons of Margin Trading
Lose More Than Invested: Buying on margin is the only stock-based investment where you stand to lose more money than you invested.
Pay Interest: Borrowing money isn’t without its costs. You have to pay the interest on your loan. The interest charges are applied to your account unless you decide to make payments.
Reduced Return Rate: If you hold an investment on margin for a long period of time, your return rate will be reduced due to interests accrued. Therefore buying on margin is mainly used for short-term investments.
Dis-qualification: Not all stocks qualify to be bought on margin. Brokers will not allow you to purchase penny stocks, over the counter securities or initial public offerings (IPOs) on margin because of the level of risk involved with these types of stocks.
Maintenance Margin: You are required to keep a minimum amount of equity in your margin account that can range from 25% – 40% (maintenance margin).
Forced Deposit/Selling: In a cash account, there is always a chance that the stock will rebound. But in a margin account your broker will force you to deposit more funds or sell off your securities if the stock price dives. This means that your losses are locked in and you won’t be able to participate in any future rebounds that may take place. Additional your broker may not be required to consult you before selling and can sell stocks you did not intend to sell.
Conclusion: Margin is a high-risk strategy that can yield a huge profit if executed correctly. The dark side of margin is that you can lose your shirt. One of the only things riskier than investing on margin is investing on margin without understanding what you’re doing. Therefore the purpose of this post was to strictly educate the reader on the basics of margin trading.
If you are new to investing, I strongly recommend that you stay away from margin, atleast until you clearly understand the pros and cons. Only invest in margin with money you can afford to lose.