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Borrowing To Invest: Is Buying On Margin Worth The Risk

You want to invest in the stock market, but you don’t have the money right now. What do you do? Well, if you can scrape at least a little bit together, you can try trading on margin. Trading on margin is only for more experienced investors, but the only way you’re going to gain that experience is by dipping your toe in the water.

What Is Buying On Margin?

Buying on margin is a form of leveraged investing. Some companies borrow money to invest in projects. You’re probably very familiar with this. For example, a company may take out a loan to develop a new product line. It may sell bonds to raise money for business expansion. It may issue stock to help propel the company forward when it has proof of concept of a new product or service.

As an investor, you’re doing something similar. You’re taking out a loan to invest in securities. With a 50 percent margin, you can buy up to twice as much stock as you could by using only your own money. Obviously, this means the profit potential is much higher.

For example, let’s say you have $10,000 to invest. You want to invest with $20,000 of capital, but you just don’t have it. The brokerage firm is willing to lend you $10,000 if you put up the other $10,000. So, you put up the $10,000 (which is 50 percent margin on the full dollar amount you want to trade with). You take the $20,000 ($10,000 of your own money, $5,000 of the brokerage’s money) and buy XYZ stock.

Right now, the stock is trading at $100 per share. You believe it will rise dramatically so you go “all in.” You’re able to buy twice as much stock and your profit potential is 100 percent higher than if you were using your own money. In other words, if the stock moves 8 percent, you make 16 percent. Here’s how the math works out:

Initial investment: $10,000

Borrowed from brokerage: $10,000

Gain: 8 percent

Investment account net balance: $11,600

When you subtract the borrowed $10,000 from your own investment (because you have to pay this back to the brokerage) you’re left with $1,600 profit on an investment of $10,000. That’s a 16 percent gain.

Now, you also have to pay interest on the borrowed money, but this usually isn’t a lot unless you hold the investment for a very long period of time. Sometimes, you can mitigate the interest cost just by choosing the right brokerage. Start researching brokers using www.brokerstance.com and go from there.

The Benefits

The benefits of margin trading should be obvious. You get to boost your net rate of return without seeking higher-risk investments. In other words, those blue chip stocks and dividend aristocrats suddenly become “superstar” investments.

It also shortens the time horizon required to meet your financial goals. If you can consistently invest in even the most conservative of investments, you’ll halve the time it takes to meet your goals.

The Margin Call

One of the worst things that can happen to a margin investor is the dreaded margin call. Your brokerage can call in the loan it gives you at any time. Worst of all, he can force you to sell off all of your securities to repay the loan. Normally, this only happens when you lose a lot of money.

And that’s the major disadvantage of margin investing. Since you’re borrowing money to invest, your gains are magnified but so are your losses. You could end up losing more than you invested – meaning you owe the brokerage money.

Other Risks

Other risks associated with margin investing all stem from the margin call. If a brokerage firm decides that your position is no longer profitable, or it thinks it’s in danger of losing money on its loan to you, it can force you to exit a position before you’re ready.

Let’s say you buy into a stock and the price tanks 10 percent almost instantly. It could scare some brokerages into calling your loan due. But you suspect that the stock will rebound next week when the earnings reports are released. The company is going through a rough patch right now, but they also have a new product launch and the financials should look great.

It doesn’t matter. The brokerage forces you to sell your position, recovers its loan, and you miss out on the gains when the earnings report surfaces. You curse the brokerage, because you had to pay commissions on the sale, plus interest for the loan, and you missed out on the upside.

Jarryd Harden has earned a reputation for offering sound investment ideas. His articles are mainly found on investment blogs.