Savvy investors can use margin to get more bang for their buck in the stock market.
They also know and respect the risks of margin when things aren't working right.
A margin account allows investors to borrow money from a brokerage to buy more securities than they otherwise could, creating the potential for bigger profits — or bigger losses.
Let's say you pay $20,000 cash to buy 1,000 shares of a $20 stock. The stock rises to $30. Your profit would be $10,000, a 50% gain on your $20,000 investment.
But what if you buy the stock with $10,000 in cash and $10,000 from a margin loan? If the stock goes to $30, your $10,000 profit would a return of 100% on your $10,000 investment.
Of course, you would have to subtract the interest on the margin loan from your profit. But buying on margin makes it possible to amplify your returns significantly.
On the other hand, margin investors can lose money very quickly. Those who borrow $2 for every $1 they invest can lose money at twice the rate of a cash investor.
In the example above, if the stock falls to $10, you will be left with only $10,000 — the $10,000 you borrowed from the broker and nothing for yourself. You would have lost your entire $10,000 investment, but a margin call from your broker would likely prevent that from occurring.
When using margin, operate under strict buy and sell rules. Investors without a few years of investing experience should stick to cash-only investing.
"I've always used margin, and I believe it offers a real advantage to an experienced investor who knows how to confine his buying to high-quality market leaders and has the discipline and common sense to always cut his losses short with no exceptions," IBD founder William J. O'Neil wrote in ".
Margin, he says, is best used in the first two years of a bull market, when three out of every four stocks go up. But when the market enters a correction, borrowing money to buy stocks is a bad idea. Three of every four stocks will go down.
Your broker may issue a margin call as the value of your portfolio falls below a predetermined level. A margin call requires the investor to pony up extra cash or sell shares to cover losses.
The best thing you can do when a margin call occurs is to sell your stocks right away. Don't send good money after bad in the hope that your stock will rebound.
"You should never invest on margin unless you're willing to cut all your losses quickly. Otherwise, you could go belly-up in no time," O'Neil wrote.
He adds that it's even more important to cut losses if your portfolio consists mostly of fast movers, and that includes tech stocks, which are generally two to three times more volatile than average.