Buying on margin can multiply profits on stock trades. It can also increase losses and with additional charges for interest can really be a cash drain.
Margin is a loan provided by stockbrokers that can be used to buy shares. Interest is charged on the loan, at a rate set by the broker. The interest rate can vary with market conditions, but brokers will try to remain competitive in order to retain accounts.
The broker must approve the account for margin, and brokers require a minimum amount of funds to be kept in the account to utilize margin. The minimum does vary by broker. Not all accounts are eligible for margin, particularly retirement accounts.
Example of Margin Stock Purchases
Investor Smith has $5,000 (plus enough for commissions) in an approved margin account which requires a minimum balance of $2,000 for margin. He purchases 100 shares of XYZ Stock at the price of $50. Without margin, he has used all the funds in his account, and cannot purchase anything else without selling XYZ or putting more funds in the account.
If XYZ is marginable, the broker will allow him buy more stock using the shares of XYZ as collateral. Not all stocks are marginable, that is, can be used as collateral for margin purchases. The broker can prevent stocks that are too volatile from being used as margin. The broker’s main interest is to be in a position to get the amount of the loan returned if the value of the stock goes down precipitously.
Example of a Profitable Use of Margin
In the example above, if the broker determines that XYZ is marginable at 50%, Smith will be able to buy an amount of stock that is up to double the amount he has in the account. It does not have to be the same stock, but a different stock must also be marginable if there are not sufficient funds in the account.
Smith does buy another 100 shares at the price of $50. He now owns 200 shares, and holds them for a month. In this scenario, at the end of the month, the stock price has risen to $55. Smith decides to sell all 200 shares, for a total sales amount of $11,000.
Smith must repay the margin loan of $5,000 and the interest on the margin loan. At 6%, interest would be $25 on $5,000. Smith has made a profit of $975, compared to the profit of $500 he would have made if he had not used margin.
Creating Bigger Losses on a Bad Investment with Margin
If, as above, Smith buys 200 shares using margin and sells in a month, but the price has fallen to $45, he will more than double his losses. When he sells the stock for $9,000, he must still repay the entire $5,000 margin loan, plus the interest of $25. He will lose $1,025 on margin, instead of the $500 he would have without margin.
Smith may decide to hold the stock until it goes up, but he will continue to pay interest, and if the stock declines enough, the broker will issue a margin call and Smith would have to add more funds to the account or sell the stock.
Margin for the Small Investor
Margin can be an effective tool for leveraging a small amount of money into big profits, but it can also accelerate losses on a poor choice. Small investors should be wary and use margin sparingly and for a limited duration, in order to prevent being wiped out.