Anyone who’s looking to invest should know their options, and about the dangers that come with them. Buying on the margin is one way of buying stocks, but it is one that comes with a fair amount of risk. So is it something you should do?
What Is Buying On The Margin?
Buying on the margin is basically taking out a loan from your brokerage company to pay for your investment. If you want to buy on the margin, there are a few rules:
- You can borrow up to 50% of the total investment. This is because the half you supply serves as the collateral.
- A broker will have a minimum investment required before they offer this feature. It is commonly $2000.
- Just as with any other loan, interest will accrue until you pay back what you borrow.
Since you will owe interest on the loan and will have to pay it back, from the brokerage’s point of view there isn’t much of a down side. They already have the other half of your investment as collateral, and they can call in the loan if the stock loses too much value.
Why Do People Buy On The Margin?
So what is it that makes margin trading seem appealing to investors? The obvious reason that people are drawn to this practice is the possibility that they will make a large profit. Since you can double the amount of your initial investment without having to actually come up with all of the initial outlay, you have a chance to reap some hefty rewards.
What Is The Risk?
It is true that a purchase on the margin can result in a very large return. However, as with any stock investment, there is always the possibility that the value of the investment will go south. If this happens, the investor is still liable for the entire speculation. And if the stock goes below a certain percentage of its original value, the brokerage will issue a “margin call.” That means the buyer must come up with the payment for the difference right away.
Is Buying On The Margin Worth It?
Buying on the margin means you are risking more money than you actually have. You can double your returns – but you can also double your losses. Plus, the loan itself isn’t free – there is an interest rate you have to cover, so even a stock that stays neutral isn’t exactly neutral for you. That means:
- If the stock goes up, you will make a higher rate of profit than you otherwise could have.
- If the stock stays neutral, you will have to pay interest on the loan as long as you want to maintain your shares.
- If the stock goes down a bit but you want to stay in, you have to pay the difference so your loan is no more than half the value of the stock – and keep paying interest.
- If the stock goes down too much for you to stay in, you have to pay back everything.
- If the stock loses over 50% of its value, you will end up owing the brokerage money.
Is Margin Buying Right For Me?
Generally, buying on the margin is not recommended for first-time investors, or anyone who is concerned about security primarily. It is a fairly dangerous practice that is usually best for wall-street players who can afford the potential risks. A careful investor who is making practical decisions will simply buy the shares which can be purchased directly.