When an investor purchases an asset using margin, they borrow the remaining funds from a bank or broker. The first payment made to the broker for the asset—for instance, 10% down and 90% financed—is referred to as buying on margin. The marginable securities in the investor's broker account serve as collateral. The entire dollar amount of purchases an investor is capable of making with any available margin capacity is reflected in their brokerage account's buying power. Margin is used by stock short sellers to trade shares.
Understanding margin
Buying on margin means to borrow money from your broker in order to increase capital investments, and ideally profits.
Let's say you invest $10,000 and earn 10%. You will be making $1,000. What if you could have borrowed an additional $10,000 and double your profits?
Investors borrow money or buy on margin to multiple their gains. However, while increasing the potential gains, the technique is dangerous because it also increases your risks of suffering grater losses.
How to buy stocks on margin
Buying on margin means borrowing from your broker to acquire more securities than you can with cash. Through margin buying, investors can boost returns if their investments outperform the borrowing cost. Investors can lose money faster with margin loans than cash.
This is why margin investing is best left to mutual fund and hedge fund managers. Some institutional investors invest more than their funds' capital because they think they can find investments with a higher return than their borrowing cost.
When buying on margin you are essentially getting a loan from your broker. And that is not free money.
Loan costs vary widely for investors with less than $25,000 in their accounts. Small investor margin loan rates range from 3% to 10%, depending on the broker. Since these rates are related to the federal funds rate, margin borrowing costs vary.
Margin risk
Margin buying has a shaky past. During the 1929 crisis, margin accounts were unregulated, which contributed to the Great Depression, according to some economists.
Can lose initial investment
Buying on margin risks losing more money than you invested. A 50% decrease in stocks half-funded with borrowed cash equals a 100% loss in your portfolio, plus interest and charges.
Say you purchase 1,000 shares of XYZ business with $5,000 in cash and $5,000 in a margin account at $10 a share. It's $10,000, minus commissions. Investors react negatively to the company's earnings report the next week, sending the stock price down by half. Now your investment is worth $5,000, and you still owe the broker $5,000 for the margin borrowing. You have lost your entire investment, plus you have to pay interest and commissions.
Margin call
Your account's equity must meet a maintenance margin. If an account loses too much money owing to underperforming assets, the broker will issue a margin call, demanding more funds or the sale of some or all holdings to pay down the margin loan.
If markets or positions drop, your broker can liquidate your account without your approval. This is an added level of risk.
Even those who recommend buying on margin caution it can amplify losses and requires producing a return above the margin loan rate.
Margin trading is inappropriate for most investors, and especially retirees.
Buying on margin
If a margin investment goes well, the gains can be large.
Liquidity
Using a margin loan to acquire more stock than investors have cash for has other advantages. Margin accounts give speedier liquidity.
In fact, some brokers claim that clients with margin accounts can transfer money faster, even if they don't buy stocks on margin.
Investors can generally withdraw cash from a stock transaction three days after selling it, but a margin account lets them borrow funds for three days while their trades clear.
Boosts bull-market returns
Boosts bull-market returns utilize a margin account to borrow money to invest. While this method might be suited for full-time traders, it is not suitable for long-term investors.
The markets can be unpredictable and volatile. If there's a large disruption, prices can shift swiftly against you, and you could owe a lot of money in a few days. Anyone investing on margin must watch their portfolio daily.
Summary
Leverage can improve gains, but it also magnifies losses. Buying on margin is risky and not worth it for most individuals. Pros should handle large gains.