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Archive for May, 2009

Buying Stocks On Margin: Using The Power Of Leverage To Make Money In The Stock Market

If you’re educating yourself about the stock market, sooner or later you’ll be introduced to the concept of buying stocks on margin. When you’re buying stocks “on margin”, what you’re doing is using borrowed money to buy stocks in order to increase your portfolio’s returns. It may sound crazy (and if you don’t know what you’re doing, then it IS crazy), but different people do it for different reasons. The biggest incentive for people to take this risk, though, is the prospect of making a lot of money investing in a stock that they believe is about to increase in value.

So how does it work when someone wants to buy shares on margin?

Let’s say you want to buy 100 shares of company ABC, and each share costs $100. You can go about it in two different ways. The first and most simple way is to pay $10,000 to buy your 100 shares. You own those shares free an clear. The other way to do it is to come up with $5,000, and have your brokerage firm lend you the other $5,000 so you can buy that same 100 shares. That extra $5,000 worth of shares is bought “on margin”

The loan is not a gift: the brokerage firm will charge you interest, thus making money off the loan (on top of the regular fee they charge for conducting the trade). And since the brokerage firm has issued you a loan so you can buy more shares, your stock will be held as collateral against the loan. If you fail to pay the loan, they have the right to just take the stock. Because it means more money for them, brokers will be willing to lend you money to buy stocks (and bonds) if you open a margin account. All you have to do is sign a few forms, and your broker runs a routine credit check on you.

The concept of leverage when buying stocks on margin

What you’re doing is essentially looking for the best short term stocks to buy while spending the least amount of money. When looking at the concept of buying stock on margin, one of the most relevant comparisons is buying a house with a mortgage. If you buy a $100,000 home with $10,000 down and a $90,000 mortgage, what you do is take ownership of a $100,000 property with only $10,000 of your own money. In our previous example, you take control of $10,000 worth of stock with an investment of half that amount.

That leverage is especially appealing when the price of the stock you bought on margin goes up. If the value of said stock doubles, then you could sell your shares for $20,000, pay off your $5,000 loan, and be left with $15,000 profit (a 200% return on your investment). Had you paid in full for your stock, your return on investment would have only been 100%: you would have sold your shares for $20,000, thus making a profit of $10,000 on your investment of $10,000.

While this looks very promising, you also have to understand that leverage works both ways. Let’s say that the stock loses half of its value; then the math is quite different. Your portfolio is now worth $5,000 (from the $10,000 it was previously). You will receive a call from your broker to put up more cash; this is known as a margin call.

A margin call occurs when the value of your collateral falls below a certain percent of your total purchase price-usually 30 to 35 percent. If the worth of your holdings drops under that level, your broker will demand that you deliver enough cash or other securities to bring your collateral back up to the required amount. If you can’t deliver sometimes by the next day-the broker will sell your stock, take back what was lent you, and collect interest.

So in our scenario, they will sell your stock ($5,000) and use that money to pay back the loan, and you’ve lost 100% of your investment (if not more, considering transaction fees and interest on the loan). If you had paid for your shares in full, you would have only incurred a loss of 50% of your investment (loss of $5,000 out of a $10,000 investment).

There are a few things you can do to prevent margin calls from happening to you.

1. You can set a stop. If you don’t let your stock go from $100 to $50 you can’t get a margin call. Had you set up a stop for, say, $75, you would have lost a lot less money. It’s definitely better to take your losses while they’re still small, than to wait and end up with a much larger loss; this is especially likely if you’ve been investing on margin.
2. Put more money into your account. If you have a great feeling about a particular stock, and you can afford to, you can always put more money into your account. In this case you’re willing to take short term losses in anticipation for long term profits.
3. Simply don’t buy on margin. Don’t think that buying on margin is the only way to make money in the stock market. If you want to invest in the long term and don’t want to take the chance that you might get a margin call, don’t borrow money. You can still make money without it.

Buying on margin can be a powerful way to leverage your money in the stock market. But as you can see, leverage is a double edged sword that must be used with caution: it can super-size your profits just like it can super-size your losses. Before jumping in, paper trade for a few months. When you reach the point where your good trades outweigh your bad ones, then you’re ready to invest your real money.

Buying Stocks On Margin: Using The Power Of Leverage To Make Money In The Stock Market

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