Talk to anyone who has lived to see (and survive) a bear market and allude to “leverage” and “margin.” Now watch them cringe. Trading on margin is a high-risk strategy that has been around for ages, helping seasoned veterans to multiply their profits and enticing rookies to empty their pockets in hopes of profits. While many are quick to draw parallels between margin trading and gambling at the blackjack table with borrowed money, the fact of the matter is that investing with margin is very common among professional money managers of all sizes; however, because it’s so risky, and there are countless horror stories in the news about rogue traders losing fortunes in minutes, merely hearing about it strikes a pessimistic tone among investors [see How To Take Profits And Cut Losses When Trading ETFs].
In reality, margin trading is an advanced concept that warrants a closer look from anyone looking to grow their arsenal of strategies. Similar to all advanced financial instruments, investing with margin requires a certain degree of experience, which is why first-time buyers on margin are often left with a sour taste and a smaller account size. As such, here we cover the basics of trading on margin, detailing the inherent risks and rewards, as well as showcasing a real world ETF trading example.
What Is Buying on Margin?
Buying on margin refers to borrowing money from your broker to purchase a bigger position than you have sufficient funds for. In other words, “margin buying” refers to a loan from your brokerage that can be used to buy more stock than you normally could afford. So how do you do it? To buy on margin, you need to have a margin account from your broker; this is different from a regular cash account, in which you are restricted to only using the money that’s actually in the account. Most brokers will give you margin account privileges as long as you meet the minimum margin, which refers to the smallest deposit necessary, generally around $2,000 [see How To Be A Better Bear: Short Selling vs. Inverse ETFs?].
In most cases, once your margin account is up and running you can borrow up to 50% of the initial purchase price of a given security. For example, if you had $10,000 in your account, your buying power would be as much as $20,000 if you were to utilize the full margin.
Like all loans, buying on margin will incur interest charges in your brokerage account based on the amount you have borrowed. Furthermore, there is the restriction of maintenance margin, which is the minimum funds in your account that must be maintained before your broker will force you to deposit more cash or sell some positions to repay the loan, referred to as a “margin call.”
Essentially, buying on margin simply allows you to leverage your assets; however, investors should bear in mind that leverage is a double-edged sword.
What Can You Buy on Margin?
The Federal Reserve Board officially regulates which securities are “marginable,” meaning that not all securities can be bought on margin. Individual brokerages have their own list of restrictions so it’s best to check with them, but for the most part, brokers will allow you to purchase most stocks trading above $5 a share, mutual funds, ETFs, and investment grade fixed income securities (municipal, corporate, or government) on margin. Margin requirements for option trading are complicated and generally vary from brokerage firm to brokerage firm [see 7 Rules ETF Day Traders Must Know].
Securities that cannot be purchased on margin due to the inherent risks involved, include: stocks under $5 a share, penny stocks, over-the-counter bulletin board stocks, and initial public offerings (IPOs).
What Are the Risks and Rewards of Buying on Margin?
As mentioned at the start of this article, buying on margin is synonymous with the concept of leverage. Remember that 50% margin allows you to buy up to double the amount that you could normally afford of a particular security. Because you are investing borrowed funds, buying on margin gives you the potential to greatly amplify your profits; likewise, if the trend turns sour, your margin trade can leave you in a bigger hole than you could have imagined [Download 101 ETF Lessons Every Financial Advisor Should Learn].
Below we offer several examples of how this sort of leverage can work for you and what happens when it goes against you. Note that for simplicity’s sake, these examples exclude trading commissions and interest charges; also we will assume that your account has a starting value of $10,000 and you intend to purchase the State Street SPDR (SPY, A), which is hypothetically trading at $100 a share.
Buying Without Margin and Price Increases $5
In this straightforward scenario, a $10,000 investment generates a $500 profit after SPY jumps $5 a share.
Buying With Margin and Price Increases $5
If you used margin in this same scenario, a $10,000 investment gives you $20,000 of buying power, which generates a $1,000 profit after SPY jumps $5 a share. After you close this transaction you will have proceeds of $21,0000, of which $10,000 are borrowed funds, thereby leaving you with a $1,000 gain on your initial investment of only $10,0000.
Buying Without Margin and Price Decreases $5
In this straightforward scenario, a $10,000 investment generates a $500 loss after SPY drops $5 a share.
Buying With Margin and Price Decreases $5
If you used margin in this same scenario, a $10,000 investment gives you $20,000 of buying power, which results in a $1,000 loss after SPY drops $5 a share. It’s important to recognize that in this example, when using margin and the market heads south, you will receive $19,000 in proceeds after closing the position originally worth $20,000; this means that you are effectively taking on a $1,000 loss from your original cash investment of $10,000 because you used borrowed funds.
The Bottom Line
Buying on margin should be entirely avoided by novices as this strategy can result in significant losses. Like all loans, margin buying will incur interest charges to your brokerage account. Remember that buying on margin is effectively using borrowed funds to gain leverage, which is a double-edged sword; those who have experience with buying on margin can utilize it to greatly amplify their returns, while the less-experienced are bound to get burned.
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Disclosure: No positions at time of writing.
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