Buying on margin allows you to invest in more shares and can expand your trading choices. Before you open a margin account, though, itâ€™s important to understand the risks as well as the potential rewards. Hereâ€™s what you need to know.
â€śBuying on margin is basically using debt to fund your trades,â€ť said David Stein, a former registered investment advisor and a podcaster at â€śMoney For the Rest of Us.â€ť â€śYou get what amounts to a line of credit from your broker, including online brokerages, and use that money to make trades.â€ť
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 youâ€™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 Reserveâ€™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 itâ€™s undervalued at $50 per share. You can afford to buy 100 shares ($5,000), but youâ€™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.
â€śIf the price does go higher, like you expect, you could repay your loan with interest and see better profits than without it,â€ť said Stein. â€śBut if youâ€™re wrong, you still have to repay the loan on top of eating the losses.â€ť
â€śAll of my accounts are on margin by default,â€ť said Larry Ludwig, a successful investor and the founder of popular investing education website Investor Junkie. â€śI use margin to make sure I have liquidity in my account and because it has other advantages.â€ť
Some of the advantages of margin trading with stocks include:
With the ability to do more with your investing dollar, itâ€™s no surprise that margin trading is an attractive strategy. However, before you decide to risk your money, itâ€™s important to understand the risks as well.
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:
With margin trading, you could see improved profits, but your losses also could be much greater than you can afford.
â€śI use margin for short-term trading,â€ť said Ludwig. â€śThat way, I donâ€™t have to pay as much in interest, and I can move quickly.â€ť
Stein agreed that margin trading can make sense for some investors if they use it carefully. â€śFor many investors, though, itâ€™s really just not worth it,â€ť he said. â€śThis is especially true if youâ€™re not going to pay it back quickly or if you canâ€™t get a good interest rate.â€ť
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 â€śmarginable assets.â€ť Each brokerage has its own definition of what is â€śmarginable,â€ť 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 donâ€™t maintain the margin required by the broker, it can make a margin call to bring you in compliance.
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, doesnâ€™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.