Buying on margin is a technique often reserved for intermediate and advanced investors through which someone borrows money from their broker in order to invest it. In the best-case scenario, buying stock on margin can increase your earnings significantly. On the other hand, you can be left in a world of hurt if the price of your investment drops. The world of margin investing is one of higher stakes, so it’s crucial to understand the concepts and associated risks before diving in.What Does Buying on Margin Mean?
Buying on margin is the purchase of a stock or another security with money that you’ve borrowed from your broker. It’s an example of using leverage, which means utilizing borrowed money to increase your potential profit.
If an investor wants to buy stock on margin, they typically must gain approval from their broker, then open a special margin account. When you buy on margin, you’re buying stock with both your money and the money you’ve borrowed. This allows you to purchase much more than you otherwise would have been able to.
Sometimes investors use margin to do things other than buying more stock. For instance, if you think that a stock is being overvalued, you may decide to borrow existing shares of that stock through your broker, then immediately sell them. If the price does indeed fall, you’ll then buy the shares back at a lower price, return them and keep the difference. This practice is known as short selling.An Example of Buying on Margin
Since buying on margin can be difficult to fully conceptualize, an example can help to illustrate it. So let’s say the current stock price of Company A is $50, and you want to buy 50 shares because you think it’s currently undervalued. This would cost $2,500. Unfortunately, you only have $1,250, half of what you’d need to buy the shares. In order to make the purchase happen, you decide to borrow an additional $1,250 from your broker.
If Company A’s stock price then goes up to $60, you’re in luck. Your 50 shares are now worth $3,000. If you sell and pay back your loan, you’ll have $1,750 left. In turn, you increased your investment by 40% even though the stock price only rose by 20%.
We also have to consider the other side of things, however. If the price drops to $40, your shares are now worth only $2,000, meaning you would have only $750 left if you were to sell. So although the price dropped by 20%, your investment shrunk by 40%.What Is a Margin Call?
A margin call can happen if a stock that you’ve purchased on margin has fallen in price. In order to protect themselves from losses, many brokers will set a minimum value for your margin account. If you fall below that minimum, the broker will issue a margin call, a demand that you either deposit additional money or sell some of the securities in the account to keep the value above the minimum.
A margin call often means that your investments haven’t gone the way you wanted them to. They exist because brokers recognize that buying on margin is a risky venture. Some brokers may even decide to sell securities in your account without your consent. This is all within the rules, as brokers are entitled to force you to reach the minimum value. To make matters worse, brokers will typically charge you commissions for these trades despite the lack of your permission.Bottom Line
Buying on margin allows you to increase the amount of money that you have to invest, thereby increasing your potential earnings. Having to live and die by the price of one security is high-risk proposition, though. If you’re comfortable taking on that kind of risk, then this practice can make significant gains without much cash on hand. Of course, this means that if you make a bad investment, you’ll be in even more trouble than you would be otherwise.
It’s easy to see the appeal of investing on margin when it goes well. However, using borrowed money inevitably raises the stakes of any investment, meaning increased risk and increased stress. Like any investment decision, speaking to an expert like a financial advisor can help you be sure that you’re on the right track.Tips for Smart Investing
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