Buying On Margin: The Big Risks And Rewards | Bankrate
If you invest $10,000 in a good stock and get a 20 percent return, you’ll earn $2,000. But what if you could have borrowed another $10,000 to buy more shares and double your earnings?
When investors borrow money or buy on margin, they look for these kinds of gains. but the strategy is extremely risky because while it magnifies your profits, it also magnifies your losses. The 2022 bear market has pushed stocks lower as investors worry about inflation, rising interest rates and a possible recession. If you have been trading on margin, you have likely suffered more than the average investor.
Reading: What is the risk of buying on margin?
Here’s what you need to know about buying stocks on margin.
how margin trading works
Buying on margin involves taking out a loan from your brokerage and using the loan money to invest in more securities than you can buy with your available cash. Through margin buying, investors can increase their returns, but only if their investments exceed the cost of the loan itself. investors can potentially lose money faster with margin loans than when investing with cash.
This is why margin investing is often best restricted to professionals like mutual fund managers and hedge funds. To get the most returns, some institutional investors invest more than the cash available in their funds because they believe they can choose investments that earn a return greater than the cost of borrowing money.
“Margin is essentially a loan you take to get more leverage on your investments,” says Steve Sanders, executive vice president of business development and marketing at interactive brokers group.
Loan costs vary considerably, especially for investors with less than $25,000 in their account. Margin loan rates for small investors generally range from 3 percent to more than 10 percent, depending on the broker. Since these rates are typically pegged to the fed funds rate, the cost of a margin loan will vary over time.
risks of buying on margin
Buying on margin has a checkered past. “During the crash of 1929, there was very little regulation of margin accounts, and that contributed to the crisis that started the Great Depression,” says Victor Ricciardi, a visiting assistant professor of finance at the University of Washington and Lee.
You can lose more than your initial investment
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The biggest risk of buying on margin is that you can lose much more money than you initially invested. a decline of 50 percent or more in shares that were half-financed with borrowed funds equals a loss of 100 percent or more on your portfolio, plus interest and fees.
For example, suppose you buy 2,000 shares of company xyz with $10,000 of your own cash plus $10,000 in your margin account at a cost of $10 per share. that’s a total of $20,000, not including commissions. the next week, the company reports disappointing earnings and shares plunge 50 percent. The position is now worth $10,000, and you still owe the broker that amount for the margin loan. in that scenario, you lose all of your own money, plus interest and fees.
could face a margin call
In addition, your account equity must maintain a certain value, called the maintenance margin. If an account loses too much money due to underperforming investments, the broker will issue a margin call, requiring you to deposit more funds or sell some or all of the holdings in your account to pay off the margin loan.
“If the markets or your overall positions drop, your broker may liquidate your account without your approval. that’s a significant downside risk,” says ricciardi.
Even those who advocate buying on margin in some situations despite the risk warn that it can amplify losses and requires a return that exceeds the margin rate on the loan.
“Margin trading is for experts who understand the mechanics of it, not the average retiree,” says Ricciardi.
benefits of buying on margin
Of course, if an investment purchased on margin does well, the returns can be very rewarding.
In addition to using a margin loan to buy more shares than investors have in cash in a brokerage account, there are other advantages. For example, margin accounts offer faster and easier liquidity.
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“For most of our clients, we like to have a margin account even if they never buy stocks on margin because they can transfer money faster,” says Tom Watts, president of Wats Capital Partners, a broker-dealer that offers services financial. to customers.
For example, investors can typically only withdraw cash from a stock sale three days after selling the securities, but a margin account allows investors to borrow funds for three days while they wait for their trades to settle.
“With a margin account, they don’t have to wait—they can access cash instantly,” says Watts. “You still have to pay interest for those three days, but it’s miniscule.” for example, a $10,000 margin loan at 5 percent interest would involve interest costs of less than $2 per day.
increases profitability in bull markets
watts says his most active clients use a margin account to borrow money to invest, but cautions that that investment strategy is best left to a full-time trader.
“If you’re at your terminal every day, have strict loss limits, and have a trader’s mindset, margin investing can be a great thing in bull markets. But investors should only do it when the market is going to continue to go up and has very strict loss limits,” Watts says.
The problem is not knowing when the market could suddenly change course, he adds. “If you have a major disruptive event, prices can move pretty quickly against you and you could end up owing a lot of money in a couple of days. Anyone who invests on margin should keep a close eye on their portfolio every day.”
Using borrowed funds to invest can give your returns a big boost, but it’s important to remember that leverage also amplifies negative returns. For most people, buying on margin makes no sense and carries too much risk of permanent loss. Margin trading is probably best left to the professionals.
* note: michael foster wrote an earlier version of this story.