One way to purchase stocks is to buy them on margin. Buying stocks on margin allows investors to pay for a fraction of the stock (usually around 50%, but it cannot go beyond this), and then borrow the rest from their broker. Also referred to as leveraging, buying stocks on margin can result in a large return when the stock goes up.Buying on margin allows you to purchase more stocks by using the assets you already have as collateral for the loan, and it also lets you to react quickly to new investment opportunities because you have the added money in your account.
However, like anything, there are risks associated with buying stocks on margin.
What Is the Danger of Buying Stocks on Margin?
Buying stocks on margin can be a risky venture and result in financial straits if you're not careful. In fact, buying stocks on margin is actually the only way in the stock market that an investor can lose more than he actually put in. Some of the dangers of buying stocks on margin include:
It's not for the novice. On the surface and if done properly, buying on margin can almost double your buying power. However, it requires a great deal of knowledge as little rules and fees can add up, leaving the investor in the hole. In addition, your margin account must stay within a certain percentage, and if it drops below that you only have a few days to replenish the account. Not all stocks are marginable, and purchasing stocks on margin can get you into trouble if you're not careful or if you don't know what you're doing.
You could end up owing more than your initial investment. If the stock goes up and you make a profit, great. But if it falls below 75% of its original value, the broker will issue what is referred to as a margin call since the investor must have at least 35-55% equity in his account at all times. A margin call mean the investor much put more money into the account. If he can't do this, however, he'll have to sell the stock, pay the broker the amount owed, which might even be more once commissions are figured in.
It requires a good deal of knowledge about marginable stocks. Let's say an investor has a margin account with $5,000 in it, giving him $10,000 buying power, as he is allowed to borrow up to 50%. The investor decides to purchase stock with his margin account that is worth $6,000. However, he does so without realizing the stocks purchased were not marginable, so he is $1,000 in debt (because his stocks don't qualify, he is not allowed to use his margin account). If this is the case, the investor will get a Fed call from his broker, telling him he has three days to put enough money to cover it into his account.
Buying on margin is similar to using a credit card. Often, when buying things on credit, people spend recklessly because they forget, either subconsciously or not, that they eventually have to pay that back, with interest. Buying on margin is similar. If you don't make money, you'll have to pay it back, plus taxes and brokerage commissions.
Buying on margin comes with a number of risks, and it's best to carefully research each one and discuss with your broker whether buying on margin is right for you.
