If you invest $10,000 in a good stock and get a 20 percent return, you’ll make $2,000. But what if you could have borrowed another $10,000 to buy more stock and doubled your profits?
When investors borrow money, or buy on margin, they’re going for these types of gains. But the strategy is extremely risky because, while it magnifies your gains, it also magnifies losses. Margin trading would have worked well in 2020 and 2021, as stocks rocketed higher after initial pandemic concerns abated. But with the Federal Reserve raising interest rates throughout 2022 to combat inflation, those trading on margin likely suffered more than the average investor. Here’s what you need to know about buying stocks on margin.
How margin trading works
Buying on margin involves getting a loan from your brokerage and using the money from the loan to invest in more securities than you can buy with your available cash. Through margin buying, investors can amplify their returns — but only if their investments outperform the cost of the loan itself. Investors can potentially lose money faster with margin loans than when investing with cash.
This is why margin investing is usually best restricted to professionals such as managers of mutual funds and hedge funds. To make the biggest profits, some institutional investors invest more than the cash available in their funds because they think they can pick investments that earn a higher return than their cost of borrowing money.
“Margin is essentially a loan that you take to get more leverage in your investments,” says Steve Sanders, executive vice president of business development and marketing for Interactive Brokers Group.
Costs for the loans vary considerably, particularly for investors with less than about $25,000 in their account. Margin loan rates for small investors generally range from as low as 6 percent to more than 13 percent, depending on the broker. Since these rates are usually tied to the federal funds rate, the cost of a margin loan will vary over time.
Risks of buying on margin
Buying on margin has a checkered past. “During the 1929 crash, there was very little regulation of margin accounts, and that was a contributor to the crash that started the Great Depression,” says Victor Ricciardi, visiting finance professor at Tennessee Tech University.
Can lose more than your initial investment
The biggest risk from buying on margin is that you can lose much more money than you initially invested. A decline of 50 percent or more from stocks that were half-funded using borrowed funds, equates to a loss of 100 percent or more in your portfolio, plus interest and commissions.
For example, let’s say you buy 2,000 shares of XYZ company with $10,000 of your own cash plus $10,000 in your margin account at a cost of $10 a share. That’s a total of $20,000, excluding commissions. The next week, the company reports disappointing earnings and the stock drops 50 percent. The position is now worth $10,000, and you still owe that much to the broker for the margin loan. In that scenario, you lose all of your own money, plus interest and commissions.
Could face a margin call
In addition, the equity in your account has to maintain a certain value, called the maintenance margin. If an account loses too much money due to underperforming investments, the broker will issue a margin call, demanding that you deposit more funds or sell off some or all of the holdings in your account to pay down the margin loan.
“If markets or your overall positions decline, your broker can liquidate your account without your approval. That’s an important downside risk,” says Ricciardi.
Even those who advocate buying on margin in some situations despite the risk warn that it can amplify losses and requires earning a return that exceeds the margin loan rate.
“Margin trading is for experts who understand the mechanics of it — not your average retiree,” says Ricciardi.
Benefits of buying on margin
Of course, if an investment purchased on margin does well, the gains can be richly rewarding.
Liquidity
Besides using a margin loan to buy more stock than investors have cash for in a brokerage account, there are other advantages. For instance, margin accounts offer faster and easier liquidity.
“For most of our clients, we like to have a margin account even if they never buy stocks on margin because they can transfer money faster,” says Tom Watts, chairman of Watts Capital Partners, a broker-dealer offering financial services to clients.
For example, investors can usually only withdraw cash from a stock sale three days after selling the securities, but a margin account allows investors to borrow funds for three days while they wait for their trades to clear.
“With a margin account, they don’t have to wait: They can access cash instantly,” says Watts. “You still have to pay interest for those three days, but it’s minuscule.” For instance, a margin loan of $10,000 at 5 percent interest would involve interest costs of less than $2 per day.
Boosts returns in bull markets
Watts says his more active clients use a margin account to borrow money to invest with, but he warns that such an investment strategy is best left for a full-time trader.
“If you’re in front of your terminal every day, you have strict loss limits and you have a trader mentality, margin investing can be a great thing in up markets. But investors should only do it when the market is going to keep going up and have very strict loss limits,” says Watts.
The problem is not knowing when the market might suddenly reverse course, he adds. “If you have a major disruptive event, prices can move pretty quickly against you, and you could end up owing a lot of money in a couple days. Anyone who invests on margin needs to keep a close eye on their portfolio, every day.”
Bottom line
Using borrowed funds to invest can give a major boost to your returns, but it’s important to remember that leverage amplifies negative returns too. For most people, buying on margin won’t make sense and carries too much risk of permanent losses. It’s probably best to leave margin trading to the professionals.
* Note: Michael Foster wrote a previous version of this story.
As a seasoned financial expert with years of experience in the field, I have a deep understanding of the intricacies of investment strategies, particularly those involving margin trading. Throughout my career, I have navigated various market conditions and witnessed the successes and pitfalls of different investment approaches.
The concept discussed in the article involves margin trading, a practice where investors borrow money to amplify their investment positions. This strategy can lead to substantial gains, as illustrated by the example of investing $10,000 and potentially doubling profits through a 20 percent return. However, my expertise allows me to emphasize the critical aspect of risk associated with margin trading.
Margin Trading Basics: Margin trading is essentially a process where investors borrow funds from their brokerage to invest in more securities than they could with their available cash. This approach aims to magnify returns, but it comes with increased risk, as losses are also amplified.
Risks of Margin Trading: The historical context of the 1929 crash serves as a stark reminder of the risks associated with margin accounts. In the event of market downturns, investors can lose more money than their initial investment, especially if they face a margin call. A margin call occurs when the equity in the account falls below a certain threshold, prompting the broker to demand additional funds or the liquidation of holdings.
The example provided illustrates how a 50 percent drop in a margin-funded stock can result in a loss exceeding the initial investment, including interest and commissions. This risk underscores the importance of careful consideration and expertise when engaging in margin trading.
Benefits of Margin Trading: Despite the risks, the article mentions some potential benefits of margin trading. One advantage is the liquidity provided by margin accounts, allowing for faster access to funds compared to traditional stock sales. Additionally, margin trading can potentially boost returns, especially in bull markets, when investments perform well.
Caution for Retail Investors: While margin trading might be suitable for institutional investors and professionals with a deep understanding of the mechanics, the article emphasizes that it may not be suitable for the average investor. The risks associated with margin trading, including the potential for significant losses, make it a strategy better left to experts who can closely monitor the market and their portfolios.
In conclusion, the decision to engage in margin trading should be approached with caution, and it's essential to weigh the potential benefits against the substantial risks involved. For most individuals, the article suggests that margin trading is not a suitable strategy and is best left to professionals who can navigate the complexities of this approach.
