Advantages With Buying Stock on Margin
Buying stocks on margin is an aggressive stock market strategy. Investors who use margin should understand both the benefit and downside possibilities of margin investing. Also, margin accounts are subject to rules that can affect the investment outcome. With the right knowledge, margin trading can be a powerful tool for the stock market investor.
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Rules
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Margin account rules are set by the Federal Reserve Board, the Financial Authority Regulatory Authority (FINRA), the stock markets and the brokerage firms. The rules set the minimum amounts of equity required to be maintained in the account for purchases and maintenance. The equity is the amount of the account holders money in the account compared to the total value.
Function
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Federal Reserve Board Regulation T states investors can borrow up to 50% of the purchase price of stock in a margin account. An investor who wants to buy 100 shares of a stock costing $50 per share would pay $2,500 and borrow the other $2,500 from the brokerage firm as a margin loan. A margin purchase allows the investor to hold twice as much stock for the same amount of money.
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Potential
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Buying stock on the margin increases the profit potential percentage. If the investor paid $5,000 cash for the 100 shares of stock and the price increased to $60, she would have a $1,000 gain or 20% profit. Using a margin loan and paying only $2,500 for the same stock produces a 40% profit. With the same $5,000, the investor could buy 200 shares of stock and realize a $2,000 gain if the stock increased by $10.
Stocks purchased on the margin that decrease in price also magnify the percentage loss. A 50% drop in the stock price will completely wipe out the investor's equity. It is possible to lose more than your initial investment on a margin purchase.
Costs
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Brokerage firms charge interest on margin loans. It is important to factor in the margin interest when calculating returns. The broker will also have a margin maintenance requirement for percentage of equity in the account. If the value of holding in your account fall below the maintenance percentage, you will receive a margin call from the brokerage to deposit more cash into the account. If you do not meet the margin call, the stocks in the account will be sold.
Warning
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If you own stock on the margin, it is possible to lose more money than your initial investment. If the equity in the account falls below the maintenance requirements, the broker has the right to sell any securities in the account without your approval to meet the requirements. You can lose money very fast in a margin account if stock prices go down.
Considerations
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Buying stock on the margin uses leverage to multiply the profits when the stock's price goes up. Falling stock prices can destroy your equity in the account. It is important to keep a close watch on stocks purchased with margin loans and sell quickly to avoid big losses. Have a target price to sell if the price increases to lock in the profit you are expecting.
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