Margin is borrowing money from your brokerage firm to buy a stock and using the securities in your portfolio as collateral. Investors generally use margin to increase their purchasing power so that they can own more stock without fully paying for it. This is a wonderful thing if the stock goes in the direction that you have bet on, but margin exposes you to the potential for catastrophic losses.
Let’s say, for example, that you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you’ll earn a 50% return on your investment. However, if you bought the stock on margin–paying $25 in cash and borrowing $25 from your broker–you’ll earn a 100% return on the money you invested (which includes the borrowed money. As you would expect, you will owe your firm $25 plus the interest on the borrowed money.
The dark side of using margin is that when your portfolio takes a downturn, substantial losses can mount quickly. For example, let’s say the stock you bought for $50 falls to $25. If you fully paid for the stock with cash, you would lose 50% of your money. However, if you bought the stock on margin, you would lose 100%, and you still must pay the brokerage the interest you owe.
The bottom line is that you should be very guarded about buying anything on margin. If you do decide to use margin, be sure you understand how a margin account works, and what happens in the worst-case scenario. Margin isn’t a credit card. You don’t have the option to pay a fixed amount every month; margin debt means that you can be forced to pay back the entire margin loan all at once if the price of the stock suddenly sinks.
Your broker has the ability to immediately sell anything and everything in your account without notice if there is a shortfall. You may still owe a sizeable amount of money, even after your securities are liquidated.
Margin accounts are very risky, and they are not suitable for most investors. Before opening a margin account, you should fully understand that:
- You can lose more capital than you have in your account;
- You may have to deposit additional cash in your account immediately to cover your market losses;
- You may be forced to sell some or all of your securities when falling stock prices reduce the value of your holdings; and
- Your broker may sell your securities without notice to pay off the loan it made to you.
You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines. Keep in mind that your brokerage charges you interest for borrowing money and how this cost will affect the total return on your investments. Ultimately, it is you who must decide whether it makes sense for you to trade on margin considering your net worth, your investment objectives, and your tolerance for risk.