Before today, I’ve always been strictly a cash investor. I’ve always been cautious as buying on margin can be a dangerous, yet rewarding tool. When you buy on margin, your broker is essentially loaning you money secured by your portfolio. Brokers charge interest rates as do any other loans. The idea is to use leverage to magnify your buying power.
Here’s an example: Let’s say you only had $1,000 of free cash laying around in your brokerage account and you wanted to invest in X company. If you buy $1,000 worth of shares and X company goes up 20% over time, your end result would be $1,200. However, if you decided to buy on margin and initially buy $1,000 with cash and $1,000 on margin your end result would be $2,000 (initial purchase) + $400 (20% gain) – $1,000 (pay back the margin loan) = $1,400. Your gains would be doubled basically. Do keep in mind that you do pay interest on the your margin loan so it does eat into your gains somewhat.
What a lot of people don’t realize is that while your upside potential is magnified, your downside potential is slightly a little more magnified. The downside is slightly more magnified because you’re paying interest on that money you borrow. All is great when the stock is headed upwards, but if you made a bad call and incur losses, you could be eating them big time.
Here’s a scenario of how you could potential lose all your capital. Same as the example above of where you buy $1k on cash and $1k on margin of company X. Company X has a totally unexpected financial scandal and drops 50%. So your total holdings is worth $1k… and you OWE $1k to your broker. So in essence you’ve lost all your capital. If the stock does drop more than 50% you’ve incurred losses greater than what you invested.
Also, remember when buying on margin, your goal is to invest in securities you are sure will beat the interest rate you’re paying on that money. If you’re interested in buying on margin. Make absolutely sure you have funds to cover the maintenance rates if things ever go sour. The maintenance rate is the percentage of funds you have to keep in your brokerage relative to the loan. If you fall below the maintenance rates, your broker may initiate a margin call where they ask you deposit more funds. If you take no action, generally brokers will liquidate your shares for you to meet your maintenance rate. One way to play it a little safer is not use all your potential buying power so if your portfolio dips a bit, you won’t get a margin call.
Margin buying is a risky and every investor should do proper thorough research before trying it. I actually am considering buying one stock in mind on margin as I don’t have any free cash in my portfolio and I’d hate to miss the opportunity. I’ll post about my first buy on tomorrow. I’m playing it fairly safe in that only using 25% of my available buying power so my entire portfolio would have to dip considerably to warrant a margin call.
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