Dennis Hammer is a writer and finance nerd with six years of investing experience. He writes about personal finance for Wealthsimple. Dennis also manages his own investment portfolio and has funded several businesses in the past. Dennis holds a Bachelor's degree from the University of Connecticut.
Investing is a straightforward formula: Invest more to earn more. At least that's what you hope happens. But if you don’t have much capital on hand, you could be disappointed in your portfolio’s earnings. Wouldn’t it be great if you could borrow money to invest? That’s a very high-risk, high-reward investment strategy called buying on margin.
What does buying on margin mean?
Buying on margin is when you borrow money from a bank or broker to purchase securities. It’s a type of leverage you can use to purchase more of the asset than you could on your own. It's a high-risk investment strategy because you could lose more money than you have yourself.
Margin refers to the amount you need to borrow for the transaction. For instance, you might put 65 percent down and finance the other 35 percent of a purchase. The 35 percent is the margin. The asset in the transaction (usually a security like stocks, bonds, or funds) is the collateral. The bank or broker who lends you money can take the security if you fail to pay back the loan.
Why would you buy on margin? Because it amplifies your buying power. If you can invest more, then you can potentially earn greater returns. It also means you can lose more.
Now, in theory, if your security increases in value, you sell it, pay back your loan and keep the earnings. The reality is—sometimes there are no earnings but instead there are loses. This means you not only lose your money but you also owe the bank or broker for the money you borrowed. When you buy on margin you're making a speculative decision with money that you don't have. That's why you should use extreme caution before buying on margin and understand the risks.Wealthsimple Invest is an automated way to grow your money like the worlds most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.
Buying on margin example
To help you understand how buying on margin works, let’s run through a simple example.
John deposits $5,000 in his margin account. He’s required to put up 50% of the purchase price, which means he can borrow another $5,000. He now has $10,000 worth of buying power that he uses to purchase a security. The security increases 3% in value which nets him $300. He then sells the security and pays back the $5,000 he borrowed.
John would have only earned $150 from his investment if he only invested the cash he had on hand. But in this example, he was able to borrow twice as much. Thus he could profit twice as much.
You can also use margin to borrow securities (instead of simple cash). You might do this if you think a stock is overvalued, so you borrow shares of the stock and immediately sell them. If the price of the stock falls, you buy the shares back at the lower price, return them to the lender (which pays off your debt), and keep the difference. This is called short selling, but it’s essentially buying on margin.
Before you can buy on margin, you need to be approved by a broker and given a margin-approved account, rather than a standard brokerage account. This isn’t like a regular cash account. You get to spend your money and the broker’s money to buy securities.
The amount of money you have in the margin-approved account determines the amount of purchases you can make. The more cash you have, the more you can borrow. The brokerage may also set a limit on how much you can borrow for purchases based on your financial situation and history (they have to protect themselves, too).
There are legal limits to buying on margin as well. In the United States, for instance, the Federal Reserve Board requires investors to fund at least 50 percent of a security’s purchase with cash. You can borrow the remaining 50 percent. The same limit exists in the United Kingdom. In Canada, investors can borrow up to 70 percent of the security’s price.
Furthermore, not all securities qualify for margin trades. Governments limit which kinds of securities you can buy on margin to protect investors from losing their savings to risky bets. For instance, most governments will not let you buy over-the-counter securities, penny stocks, and initial public offerings (IPOs) on margin. Individual brokerages may have additional restrictions.
The risks of buying on margin
If the idea of using someone else’s money to invest has you salivating, take a minute to consider the risks. A lot of people have lost a lot of money by buying on margin.
1. Bigger losses
The same power that can magnify your gains can also magnify your losses. If you buy a security and its price falls, not only will you fail to earn any money, you’ll also fail to pay back what you borrowed. You’ll have to make up the difference from your pocket.
Let’s go back to our example from above. John uses $5,000 of his money and $5,000 in borrowed money to buy a $10,000 security. Instead of gaining 3 percent, let’s say it loses 3 percent. Now the security is only worth $9,700. John still has to pay back the $5,000 he borrowed, which means his original investment is down to $4,700, a loss of $300.
If John had only invested his own money (without buying on margin), he would have only lost $150. In this case, buying on margin increased his losses.
2. Cost of interest
You might be thinking, “If I buy on margin and the security falls in price, I’ll just hold it until it rises again, just like I would with securities I buy normally.” Unfortunately, it’s not that simple. Buying on margin is effectively taking out a loan. What do all loans come with? Interest.
The broker will charge interest on the financed portion when you buy on margin. They will calculate the interest daily, but most brokerages post it to your account once each month. The longer you hold a security that you bought on margin, the more it will cost. And due to compounding interest, you’ll need a greater return just to break even. This is why margin is almost exclusively used for short-term investments.
3. Margin call
Your brokerage will require you to maintain a specific percentage of equity in your margin account. This number—called the maintenance margin—is based on the types of securities you own and whether you buy shares or use short selling.
If that percentage falls to low (meaning your account lost too much money due to poor investments), the broker will issue a margin call. This is a demand to deposit more money or sell some of your holdings to pay down what you borrowed. In some cases, the broker can liquidate your entire margin account without your approval to pay off your debt.
How to buy on margin
Your first step is to consider other alternatives to buying on margin. While there’s always some risk when you invest, margin trades are especially risky, even for experienced investors. If you wouldn’t call yourself experienced, you should probably stay away from this kind of trading.
Ask yourself— what kind of investing is right for me? Automated investing through low-fee funds is probably suitable for many people without high-interest debt who want to "set and forget" their investments. If you want to play around with trading yourself and buy individual securities, use commission-free trading in a standard brokerage account without margin. Even a simple high-yield savings account is a low-risk way to grow your money and probably better for short term savings goals.
If you really want to make trades by buying on margin, here are the steps you'd take to do it.
Step 1: Open a margin account
You’ll need to open a margin account with a brokerage. Not all brokerages permit buying on margin because of the risks we mentioned above. If they issue a margin call on your account but you can’t pay, they’ll be forced to eat the loss.
You’ll need to complete an application with the brokerage before you can open an account. The application is more involved than an application for a checking or savings account.
Step 2: Fund the margin account
Your margin account will have a minimum margin. This is a minimum amount of cash you’ll need in the account. This figure will depend on your country and the brokerage. In the United States, for example, you usually need to fund the margin account with at least $2,000.
Step 3: Determine your buying power
Your next step is to find out how much margin you can access. It’s not the same for everyone. Your broker may place limitations on your buying power based on the information in your application or your credit history. Your broker will have this information, usually somewhere on your trading account’s interface.
Step 4: Make a margin trade
Buying securities on margin is similar to making any other trade, you just have access to more money. Depending on your location and brokerage, you’ll be limited as to how much you can borrow. Check with your broker to learn this limit. We implore you not to risk your entire portfolio on a single trade!
Step 5: Maintain your account
Once you buy on margin, you’ll need to make sure there’s enough of your money in the account to hit your maintenance margin. This is a minimum amount of equity that must be in your account to keep it open. Your broker will have this information. If you can’t maintain this minimum, your broker will issue a margin call.
Is buying on margin right for you?
Buying on margins is not for beginners. In fact, it’s not for anyone who can’t spend a significant amount of time analyzing their portfolio and the market. You have to be confident that your purchases will increase in value. You also have to monitor your margin trades closely.
Most importantly, buying on margin requires a risk tolerance most novice investors don’t have, especially when they’re playing with their retirement funds. Watching your account fall dramatically is remarkably stressful when you depend on that money for the future.
Buying on margin can amplify your gains, but it also deepen your losses. Make sure you understand the consequences of every margin trade before making your purchase.
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