At first glance, buying on margin can seem like a complicated concept. In actuality, the rules of this practice are quite simple.
First things first: what is margin buying? Well, that’s when you borrow money from a brokerage firm to buy stocks or meet financial needs. This borrowed money is also known as a margin loan.
The catch is that each brokerage firm can define which stocks are marginable. That said, some facilities offer loans against shares of non-marginable securities as well.
Want to find out more about margin investing? Here are the main things you need to know.
How Does Margin Work?
To trade on margin, you need to open a margin account. This involves an initial investment of at least $2,000, which is known as the minimum margin. Once your account is operational, you can borrow up to 50% of a stock’s purchase price.
It’s worth noting that most investors don’t borrow to that extreme. The reason is simple: the more money you borrow, the more risk you take on. Of course, some brokerages insist on depositing even more than 50% of the purchase price.
The Benefits
The main benefit of buying stock on margin is that it enables you to leverage your gains. In other words, you’ll be able to buy more shares than by doing it with cash only. This method could see you double your return on investment.
Also, you can use your margin account to diversify your portfolio. If you’re heavily concentrated in a couple of sectors, you can add more positions in other sectors. If your portfolio is already diversified, you can short sell a specific sector.
The Risks
Much like amplifying gains, margin trading can do the same with losses. In certain situations, you may end up losing over 100% of your investment. Margin accounts also have a high rate of interest, which can fluctuate during margin debt.
Finally, there’s the dreaded margin call. If your securities have a sharp decline, you may need to come up with a lot of cash or marginable stock immediately. If you can’t, the brokerage firm can sell your securities without further notice.
Is Buying on Margin Worth It?
With all this in mind, it’s easy to conclude that margin trading isn’t a great fit for a buy-and-hold strategy. The interest cost on margin debt can make a large dent in your profits, and it will only add up over time.
Instead, consider using your margin account for short-term trading. When used this way, a margin loan can be a great way to gain some leverage. If you do decide to go with this strategy, start off slow and learn by experience.
How to Manage Margin Trading
When using margin, keep in mind that you’ll need to manage your loan and investments carefully. Be prepared to take a loss instead of hoping that the stock will turn around. Above all else, never ignore a margin call.
Interested in more information on buying on margin? Contact us, and we’ll get back to you soon.
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