Wednesday, 17 July 2024

Margin Trading: How Borrowing Money to Buy Stock Can Be Risky

Margin Trading: How Borrowing Money to Buy Stock Can Be Risky
13 Jan
woman using laptop computer
Once you become more comfortable with investing, it’s natural to want to take it up a notch and try to get more out of each investing dollar. One way to get more bang for your investing buck is to use margin trading.

Buying on margin allows you to invest in more shares and can expand your trading choices. Before you open a margin account, though, it’s important to understand the risks as well as the potential rewards. Here’s what you need to know.

What is margin trading?

“Buying on margin is basically using debt to fund your trades,” said David Stein, a former registered investment advisor and a podcaster at “Money For the Rest of Us.” “You get what amounts to a line of credit from your broker, including online brokerages, and use that money to make trades.”

A cash account, on the other hand, allows you to trade based only on your available funds. You either need to transfer additional money into the account or sell some of the assets in your portfolio in order to have ready cash for your next market order.

The hope with margin, Stein said, is that you’ll be able to use the capital to make good investments that will return enough to beat the interest you pay and result in larger profits than you otherwise would have. According to the Federal Reserve’s Regulation T, you can borrow up to 50% of the value of your purchase.

For example, you might see a stock you think is poised to grow quickly. You want to take advantage of the fact that you think it’s undervalued at $50 per share. You can afford to buy 100 shares ($5,000), but you’d like to be able to purchase another 50 shares. In order to make it work, you borrow $2,500 from your broker and place the market order.

“If the price does go higher, like you expect, you could repay your loan with interest and see better profits than without it,” said Stein. “But if you’re wrong, you still have to repay the loan on top of eating the losses.”

Buying on margin: the advantages

“All of my accounts are on margin by default,” said Larry Ludwig, a successful investor and the founder of popular investing education website Investor Junkie. “I use margin to make sure I have liquidity in my account and because it has other advantages.”

Some of the advantages of margin trading with stocks include:

  • Leverage: This is the advantage most people think of, according to Ludwig. “You can magnify your gains by increasing your buying power,” he said.
  • Increased access to investing options: In some cases, you can’t execute more advanced trading strategies without access to the liquidity that comes with a margin account. “With regular market orders, you have to wait for the transaction to clear before making your next move,” said Ludwig. “Margin gives you more flexibility because the capital is available to you right now.”
  • Diversify your portfolio: If your portfolio is more concentrated right now, you can use margin to purchase securities that allow you to diversify without selling any of your current assets.
  • Flexible repayment: For the most part, you can repay the margin on your own time schedule as long as you remain within the maintenance requirements.

With the ability to do more with your investing dollar, it’s no surprise that margin trading is an attractive strategy. However, before you decide to risk your money, it’s important to understand the risks as well.

Buying on margin: the risks

While you could improve your investing performance with the help of margin, there are issues with using debt to finance your investment purchases, including the following:

  • Magnified losses: The biggest risk of margin trading is the fact that your losses could be magnified. Not only do you end up with your investment losses, Stein pointed out, but you also have to repay your loan.
  • Interest on your loan: “For many individuals, it’s hard to get a good rate on your loan,” said Stein. “You might pay as high as 9%, although some brokers have better rates in the 3% to 4% range.” In order to be successful, your return needs to be enough to at least cover your interest charges.
  • Potential for a margin call: “If your stock goes down enough and you have a deficit between your cash and the value of your assets, they do a margin call,” said Ludwig. “You have to immediately come up with the difference between what you have in your account and what you owe. If you can’t, they force a sale of your assets.”
  • Lose more money than your initial investment: If you keep needing to add more capital to your account to maintain requirements and your portfolio keeps losing, you could owe more than your initial investment.

With margin trading, you could see improved profits, but your losses also could be much greater than you can afford.

“I use margin for short-term trading,” said Ludwig. “That way, I don’t have to pay as much in interest, and I can move quickly.”

Stein agreed that margin trading can make sense for some investors if they use it carefully. “For many investors, though, it’s really just not worth it,” he said. “This is especially true if you’re not going to pay it back quickly or if you can’t get a good interest rate.”

How to set up a margin account

If you decide margin trading is right for you, setting up an account is fairly straightforward. Check with your current online broker to see if it has a margin option. Many brokers that allow you to trade individual stocks also provide the ability to borrow.

Depending on the broker requirements, you might be able to open a margin account with as little as $2,000 or that much in “marginable assets.” Each brokerage has its own definition of what is “marginable,” including stocks, bonds and funds.

You also need to be aware of the maintenance margin. For example, a TD Ameritrade account that is approved to trade on margin is required to have at least $2,000 in cash or securities and at least 30% of its total value as equity. If you don’t maintain the margin required by the broker, it can make a margin call to bring you in compliance.

Should you engage in margin trading?

In the end, whether you should buy on margin depends on your risk tolerance and your plan for the money. Ludwig uses his margin account for flexibility and liquidity, keeping trades short-term to avoid high interest costs. Stein, on the other hand, doesn’t see much benefit for most individual investors, even though it works well in some cases.

Carefully consider your own situation and make sure you risk only what you can afford to lose.

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Miranda Marquit


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