Define Buying Stock on Margin & Short-Selling

Margin and short-selling can open opportunities that would not exist otherwise.

Most people purchase stock with cash that they have on hand and hope to sell it after the price increases, but there are alternatives to this straightforward plan. Two of the most common alternatives to "buying long" are "selling short" and "buying on margin."

Short-Selling

Professionals in finance sometimes make reference to speculation and arbitrage. In both of these trading activities, the investor attempts to buy an asset at one price and sell it at a higher price. This is often summed up in the phrase, "Buy low, sell high." However, is also possible to sell high before buying low. This is called selling short. In selling short, the investor borrows shares of the security from his broker and immediately sells them. Since he believes that the price of the security will decrease, he expects to pocket some money. At a later time he purchases the shares on the open market and returns them to the broker. His profit will be the difference in price between when he borrowed the shares and when he purchased them from the market (less any transaction costs).

Margin Buying

Another common method of making money in the stock market is to utilize trading on margin. A margin account is simply a line of credit the investor has with his broker. By having more money available to invest, potential gains are increased. Any funds borrowed for purchasing stock on margin will eventually have to be repaid, and interest is charged on a margin loan. Typically, investors to whom brokers extend margin accounts are established customers who hold significant assets with the broker. Those assets often constitute collateral, protecting the broker should the investor otherwise be unable to repay the margin loan.

Dangers of Shorting

Neither of these activities should be undertaken recklessly. When purchasing a stock "long," the maximum that can be lost is the amount invested in the security (the stock can decrease in price, or even become completely worthless should the company go bankrupt). This is not the case when selling short. If the shorted stock rises in price, the investor will still have to purchase it from the market to return the shares to the broker. Because there is no defined maximum to which the price can increase, there is no maximum loss that a short-sell can result in.

Margin Risks

Margin accounts, like any other form of debt, can also present a risk. If stock purchased on margin decreases in price, the broker may require payment of cash towards the loan. If such payments cannot be made and the price of the stock drops too low, a margin call may be made. This orders all the shares of the stock be sold immediately, and the proceeds thereof applied to the margin loan.

Advice

If you have a stockbroker or financial advisor, he can provide you more detailed information about the opportunities and risks of margin accounts and selling short. Online brokerages often have extensive tutorials or detailed articles about these practices. Whether it takes the form of a discussion with a professional or your own research online, a well-informed investor will usually be far better off.

References

• Morningstar Website: Buying on Margin
• The Motley Fool: Margin
• The Motley Fool: Short-Selling, Is It For You?