Buying stocks on margin can greatly improve your return, but can also increase your risk.
With margin, you can buy more shares than you could otherwise and amplify your return. There are advantages and disadvantages to this. There are times when using margin makes sense, and times when investors should not touch the stuff.
Margin is leverage: It lets you buy stocks without putting up all of the required capital. Under current regulations, you put up half of the position's value and borrow the other half from your broker.
This 2-to-1 leverage factor is the main reason why investors use margin. If a trade works in your favor, your profit will be double whatever you'd get from an ordinary trade.
For example, if you buy 1,000 shares of a $50 stock in a cash account. You'll need to have at least $50,000 to buy the shares.
If you're right on your trade and the stock rises to $60, your return will be 20% ($10,000 profit from the $50,000 investment).
But if you use margin, putting up $25,000 and borrowing the rest from your broker, your gain will be 40% ($10,000 from the $25,000 investment).
You can double your money if a stock jumps 50%. That's the power of margin. But margin cuts both ways. If you're wrong, you'll lose money twice as fast. A 50% loss will wipe you out.
If you're on margin and your equity level falls below your broker's maintenance margin requirement (the minimum balance on your leveraged trade), you'll need to put up more equity or sell.
Faced with this situation, it's better to sell shares than to put up more money.
Rookie investors should not use margin until they've had a few years of market experience under their belt.
The best time to be on margin is within the first two years of a new bull market, when the overall market is acting right and leading stocks are breaking out of proper bases. That's a good time to use margin, because that's when the market tends to do its best.
The time to get off margin is in a market correction.
You should sell shares and raise as much cash as possible when distribution days start piling up, or leading stocks start showing topping signals.
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