Should You Trade Stocks on Margin?
Trading on margin is actually trading using money that you borrow from your brokerage firm. The stocks in your portfolio are the collateral for the loan. Trading on margin has many benefits, but there are also drawbacks and serious risks involved. The decision to trade on margin is one that needs to be considered on an individual basis, while taking into account all of the benefits and pitfalls that it involves.
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Mechanics
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When you trade on margin, you use your investment account balance and the stocks in your portfolio as collateral for a loan from your brokerage firm. You then use the money from the loan to buy additional investments, such as stocks and bonds. Your brokerage firm can request that you pay back the money that you borrow at any time.
Margin Interest
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The brokerage firm charges interest on the money it loans to you on margin. Typically, the interest rate is approximately two to four times higher than the interest rate the brokerage firm pays on money market accounts. The margin interest that you pay to your brokerage account must be taken into consideration when deciding whether to trade on margin.
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Margin Calls
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Your brokerage firm will set a limit on the percentage of your account net worth that can consist of securities that are owned with money that you borrow on margin. Each brokerage firm has its own limits, and your particular limit may be determined by your financial situation. If the value of your stocks declines and you exceed this margin requirement, your brokerage firm will issue a margin call. When you get a margin call, you will be forced to either deposit more cash into your account or sell some of your securities in order to meet the margin requirements.
Leverage
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The benefit, as well as the risk, of buying stocks on margin is that it allows you to leverage your portfolio. For example, assume your portfolio is valued at $100,000 and you are able to make a return of 10 percent a year. Under these circumstances, your profit will be $10,000 per year. Now assume that you trade on margin and your brokerage firm gives you margin credit equal to 100 percent of your account balance. This gives you $200,000 to invest. Assuming that your return stays at 10 percent per year, you will have a profit before paying the margin interest of $20,000 per year. Of course, the scenario can be reversed if you have a negative return on your investments. Using leverage through margin can be both a great benefit and a dangerous risk.
How to Open a Margin Account
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If you conclude that buying stocks on margin is appropriate for you, you will need to open a margin account with your brokerage firm. They will provide the necessary paperwork, as well as their rules and policies regarding margin accounts. After you submit the paperwork, the brokerage firm will evaluate your financial condition, trading history and possibly your credit score before they approve you for margin trading. Since brokerage firms have their own rules regarding margin accounts, it is important that you understand them before you begin to trade on margin.
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