Buying on margin allows you to buy more shares than you would normally be able to afford – it’s a way of using leverage. This may mean potentially greater returns. But it also comes with greater risks – you can lose more money than you originally invested.
6 things to know about buying on margin:
1. Margin account – You have to open a margin account to buy on margin.
2. Minimum investment amount – The investment firm sets the minimum amount you must deposit in a margin account. This is sometimes called the minimum margin.
3. How much you can borrow – This depends on the price of the stocks you’re buying. Your investment firm may lend you up to 70% of the money you invest. This is called your maximum loan value.
4. Interest charges – The interest charges on the loan are applied to your account. Depending on what you invest in, you may be able to deduct the interest on money you borrow to invest.
5. Collateral for the loan – The stocks you buy are used as collateral for the loan. You have to keep enough assets in your margin account to cover the loan value at all times.
6. Margin call – If your stocks drop in value, your investment firm may ask you to put more money into your account to maintain your margin. This is known as a margin call. If you don’t put in more money, the firm has the right to sell your stocks and other investments in your account to cover the margin call.
3 key risks:
1. You can lose more than you invested – If your investments go down in value, you still have to pay back your loan and interest. You may have to put up more margin to maintain your account. If you don’t, your investment firm can sell your investments to cover the margin call. You could lose more money than what you originally invested.
2. It costs more to invest – In addition to trading commissions, you have to pay interest on the loan. But depending on what you invest in, you may be able to deduct the interest on money you borrow to invest.
3. The interest rate can go up – The interest rate on your margin account can change at any time. It may cost you a lot more than you thought to pay back what you borrowed.
Certain economists have advocated that margin should be used primarily by the young with little to risk and thus more to gain through the use of leverage. A good synopsis of this position can be found here.
In general, the possible conclusion is that margin amplifies a portfolio’s performance; it makes losses and gains greater than they would have been if the investment had been on a strict cash-only basis. The primary risks are market and time; prices may fall even if an investment is already undervalued and / or it may take a significant amount of time for the price of a stock to advance, resulting in higher interest costs to the investor.