If you invest $10,000 in a good stock and get a 20% return, you’ll make $2,000. But what if you could borrow another $10,000 to buy more shares and double your profits?
When investors borrow money or buy on margin, they are after these profits. But this strategy is extremely risky because it magnifies your losses as well as your profits. A bear market in 2022 has sent stocks lower as investors worry about inflation, rising interest rates and a possible recession. If you trade on margin, you may lose more than the average investor.
Here’s what you need to know about buying stocks on margin.
This is how margin trading works
Margin buying involves taking a loan from your broker and using the funds from the loan to invest in more securities than you can buy with cash. Margin purchases allow investors to increase their returns — but only if their investment exceeds the cost of the loan itself. Investors can lose money faster with margin loans than with cash.
For this reason, margin investing is generally best limited to professionals such as mutual fund and hedge fund managers. To maximize returns, some institutional investors invest more than the cash available in their funds because they believe they can choose investments that return above the cost of borrowing.
“Margin is essentially a loan where you can have more leverage over your investments,” said Steve Sanders, executive vice president of business development and marketing at Interactive Brokers Group.
Loan costs vary widely, especially for investors with less than $25,000 in accounts. Margin lending rates for retail investors generally range from 3% to over 10%, depending on the broker. Because these rates are usually tied to the federal funds rate, the cost of margin loans can change over time.
Risk of Margin Buying
Margin buying has had a turbulent past. “Margin accounts were barely regulated during the 1929 crash, which led to the crash that sparked the Great Depression,” said Victor Ricciardi, visiting professor of finance at Washington and Lee University.
May lose more than your original investment
The biggest risk of buying on margin is that you may lose more money than you originally invested. A 50% or more drop in semi-leveraged stocks equals a 100% or more loss on your portfolio, plus interest and commissions.
For example, suppose you use your $10,000 in cash plus $10,000 in your margin account to buy 2,000 shares of Company XYZ at $10 per share. Total $20,000, not including commissions. In the following week, the company reported disappointing earnings and the stock fell 50%. The position is now worth $10,000 and you still owe the broker that much margin loan. In this case, you will lose all your own funds as well as interest and commissions.
May face margin calls
Additionally, the equity in your account must maintain a certain value, known as the protection margin. If the account loses too much due to underinvestment, the broker will issue a margin call requiring you to deposit more funds or sell some or all of the assets in your account to repay the margin loan.
“If the market or your overall position falls, your broker can liquidate your account without your consent. This is a key downside risk,” Riccardi said.
Advocates of buying on margin, even though there are risks in some cases, warn that doing so magnifies losses and requires returns that exceed margin lending rates.
“Margin trading is for experts who understand the mechanics, not the average retiree,” Ricciardi said.
Advantages of Margin Buying
Of course, when an investment bought on margin performs well, the returns can be very lucrative.
In addition to using margin loans to buy more stocks than investors have available in a brokerage account, there are other benefits. For example, margin accounts provide faster and easier liquidity.
“For most of our clients, we’re happy to have a margin account, even if they never buy stocks on margin, because it allows them to move money faster,” said Tom Watts, chairman of broker-dealer Watts Capital Partners. Z said it provides financial services to customers.
For example, investors can typically only withdraw cash from a stock sale three days after the securities are sold, but margin accounts allow investors to borrow funds for three days while waiting for the trade to settle.
“With a margin account, you don’t have to wait: you get cash right away,” Watts said. “You still have to pay interest for those three days, but it’s very little.” For example, a $10,000 5% margin loan would incur less than $2 a day in interest costs.
Increase returns in a bull market
Watts said his more active clients use margin accounts to borrow money to invest, but he cautions that this investment strategy is best reserved for full-time traders.
“Margin investing in a rising market can be a good thing if you are sitting in front of the terminal every day, with strict loss limits and a trader’s mindset. But only if the market continues to rise and there are very strict loss limits Investors should do so,” Watts said.
The problem, he added, is not knowing when the market will suddenly change direction. “If you have a big disruptive event, prices can move against you quickly and you could owe a lot of money within a few days. Investing on margin means keeping a close eye on your portfolio every day.”
Investing with borrowed funds can significantly increase your returns, but it’s important to remember that leverage can also magnify negative returns. For most people, buying on margin doesn’t make sense and carries an exorbitant risk of permanent loss. It is best to leave margin trading to the professionals.