Investing on margin is similar to purchasing a home. Most home buyers borrow money to be able to purchase a
larger home than they could afford if they had to pay cash for the entire purchase price. Investors that use margin borrow money to increase the amount of stocks they're able to buy.
The primary reason investors use margin is to increase their investment returns. Unfortunately, using margin can work against you just as easily as it can work in your favor.
Investing Without Margin
Let's start by looking at an investment made without the use of margin. Assume you purchase 100 shares of ABC Industries when it's trading at $50 per share. Your total investment would be $5,000 (100 shares x $50 per share = $5,000 investment).
Assume the stock price of ABC Industries climbs to $55 per share and you sell your total holdings for $5,500 (100 shares x $55 per share = $5,500 proceeds). This would give you a profit of $500 ($5,500 proceeds - $5,000 investment = $500 profit) which represents a 10% gain on your initial investment ($500 profit / $5,000 investment = 10% gain).
Using Margin To Magnify Gains
Now let's assume you used margin for your initial investment in ABC Industries. Assume you invest $2,500 of your own money and borrow $2,500 from your brokerage firm for the initial investment. You then purchase the same 100 shares for a total of $5,000 (100 shares x $50 per share = $5,000 investment).
You would still realize a profit of $500 if ABC Industries climbs to $55 per share and you sold your shares (100 shares x $55 per share = $5,500 proceeds - $5,000 initial investment = $500 profit). However, due to the fact that you only used $2,500 of your own money, that $500 profit now represents a 20% gain on your money ($500 profit / $2,500 investment = 20% gain).
In this scenario, borrowing 50% of the initial purchase amount doubled your gain from 10% to 20%! Of course in the real world you'd pay interest on the money you borrow and might pay trading commissions, but you'd still end up better for using margin in this scenario.
Stocks Don't Always Go Up
Margin
is a double-edged sword. Using margin is great when stocks go up, but even a
small drop in price could be enough to wipe out your initial investment if you
are using a lot of margin.
To illustrate this risk, assume you purchase 100 shares of ABC Industries on margin at $50 per shares as you did in example above, but this time the price of the stock declines. You would realize a -$500 loss if you sold your holdings when ABC Industries was at $45 per share (100 shares x $45 per share = $4,500 proceeds - $5,000 investment = -$500 loss).
You only invested $2,500 of your own money since you borrowed 50% of the initial investment using margin, but this loss now represents a 20% loss on your investment because you used margin (-$500 loss / $2,500 investment = -20% loss)! Investing on margin looks great when stocks go up, but it doesn't take much of a price decline to realize how dangerous using margin can be!
Some Of The Risks Associated With Buying On Margin
(1) Stocks don’t always go up – Using margin magnifies your losses when stocks decrease in value.
(2) You can lose more than you deposit – If the securities you
purchase decline in value, you may be required to deposit additional funds to
cover the losses. This is called a margin call.
(3) Your brokerage firm can force the sale of securities – If
you are required to deposit cash to cover your losses, your brokerage firm has
the right to sell securities in your account to meet the margin call if you
don’t deposit money in time.
(4) You pay interest even if you lose money – Interest will be
charged on your margin balance whether or not you make money on the trade, and paying interest to lose money just adds insult to injury!
Using margin as a way to increase returns is one of the biggest mistakes that investors make. Make sure you know what you're doing - and understand all of the risks involved - before using margin in your accounts.
Using margin as a way to increase returns is one of the biggest mistakes that investors make. Make sure you know what you're doing - and understand all of the risks involved - before using margin in your accounts.
To learn more about our company - and find out how we are different from other financial advisors - call (210) 587-6433 or visit www.VannoyAdvisoryGroup.com.
