Margin trading is an inherently risky form of trading that can turn even the safest blue-chip stock purchases into high-risk gambles. When the stock performs well, traders can make a lot of money, but if things go south, shareholders stand to lose big.
There are two major risks for investors investing on margins:
In the investment world, a margin is money borrowed from a brokerage firm in order to buy stocks. Buying on margin involves an investment where the investor pays only a percentage of the asset's total value and a broker lends the rest. The "margin" is the difference between the value of securities held by an investor and the loan amount from the broker.
The main draw of margin investing is that it increases your purchasing power by allowing you to use someone else's money. However, it also involves more risk as buying on margin amplifies the effects of your losses.
Say there's a company you want to invest in at $10 per share. You have $2,000 in your brokerage account -- which would buy you 200 shares -- but you want to increase the stake to 300 shares so you borrow the extra $1,000 from your broker on margin. This means you have increased your purchasing power by 1/3 to make the full investment. Over the next few months, the share price of this company jumps 150% to hit $25 a share.
This means that your initial investment of $3,000 has ballooned to $7,500. Happy days! Of course, you still need to pay back that $1,000 you borrowed (plus interest) to the broker, but nonetheless, you've made a higher return of roughly $3,500 versus $3,000 you would have made with just your own $2,000. This is because the extra money your broker loaned you leverages the degree of your return.
However, your losses are leveraged by margin too. If the investment goes the other way and the share price cuts in half -- down to $5 a share -- you'll be left with a stake worth $1,500. Don't forget that you still owe the broker back their full $1,000 (plus interest) though, which means that, in reality, you only have $500 left out of the $3,000 you spent -- a devastating loss of more than 83%. For comparison, if you had experienced the same drop on the investment of $2,000 of your own money, your stake would be down to $1,000. Not great, but not as bad as it could have been on margin.
This is also known as leveraging your downside and is the first major risk of investing on margins.
To make things more risky, many brokers also require that investors with a margin account keep a minimum amount of capital in their account, known as the maintenance margin.
By enforcing this minimum, investors can sometimes find themselves faced with a margin call if their investments are decreasing in value. A margin call refers specifically to a broker's demand that an investor deposit additional money or securities into the account so that it is brought up to the maintenance margin.
This means that if your investment is losing money, you might be forced to either add more money to your account or to sell your position outright, thereby locking in the losses. In some cases, your broker can even sell your stock without your permission.
This is the second big risk of investing on margins -- losing control of your assets altogether.
"One of the greatest lessons in my life came at the age of 25 when I made and then promptly lost a small fortune. At the time, it was more money than I'd ever imagined I would have in my mid-twenties."
There are a lot of risks associated with margin investing and the benefits don't outweigh the potential cost. Borrowed money always comes at a cost, usually in the form of interest, but also in terms of the extra leverage you are putting on your account.
Never borrow to buy, instead, save first and then invest with your own money, so that you can maximize your success in the market.
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