Almost every investor is tempted by the idea of accelerating their returns.
On average, theS&P 500returns about 9% every year with the dividends reinvested. That's enough to build substantial wealth over a long period of time, and it's a relatively low-risk way of doing it. However, for investors willing to take on more risk, there are ways to increase your potential returns by adding leverage. One of the most popular ways of doing this is trading on margin.
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What is margin?
The simple definition of margin is investing with money borrowed from your broker.
There are two primary types of brokerage accounts. In a cash account, you invest your own money. In a margin account, you can borrow from the brokerage based on how much you have invested. When you invest with a margin account, you're able to purchase stocks according to your "buying power," which includes both your own cash and a loan against the money you have invested.
What is margin trading?
Buying stocks on margin is essentially borrowing money from your broker to buy securities. That leverages your potential returns, both for the good and the bad, and it's important for investors to understand the implications and potential consequences of using margin.
First, using margin means paying interest to your broker for the money you're borrowing. At Fidelity, for example, the interest rate you'll pay on margin balances up to $24,999 is 8.325%. When you compare that rate to the 9% to 10% potential annual return in stocks, you'll quickly recognize that you're taking the risk, but the broker is getting much of the rewards. Because of interest, when you use margin you have to worry about your net profit margin, or your profits after paying interest, which will be less than your investing gains.
Investors should also be aware that brokerage firms have initial margin requirements, or minimum margin requirements, requiring the investor to put a minimum amount in the account before they can borrow from the broker. At Fidelity, you must put in $2,000 to use margin. In order to buy an individual stock, the margin requirement is 50%, meaning if you want to buy $10,000 of a stock, you have to put in $5,000 in equity. There are also maintenance margin requirements of at least 25% equity, which would apply when account values fall, and that rate may be adjusted depending on how the account performs and broader market volatility.
Buying on margin example
Assume you have $1,000 in cash and want to buy $2,000 worth of a stock that trades at $10 a share. You can put up $1,000 of your own money, borrow $1,000 from your broker, buy 200 shares, and you'd own $2,000 worth of that stock. Your net account balance would still look like you have $1,000, but it would show up as $2,000 in stock and a $1,000 margin loan from your broker.
If the stock went up from $10 to $12, that's a 20% increase above your purchase price. At that point, your 200 shares would be worth $2,400, and your account balance would reflect a total value of $1,400 ($2,400 in stock, minus the $1,000 margin loan). That's a 40% increase to your account value on only a 20% increase in the stock price.
Of course, margin cuts both ways. Say that stock instead dropped 20%, from $10 to $8. At that point, your 200 shares would be worth $1,600, and your account balance would reflect a total value of $600 ($1,600 in stock, minus the $1,000 margin loan). That's a 40% decrease to your account value on only a 20% decrease in the stock price.
There's a bigger risk in margin trading than simply losing more money than you otherwise would have.
What is a margin call?
When you have a margin loan outstanding, your broker may issue something known as a margin call, particularly if the market moves against you. When you get a margin call, your broker can demand you pony up more cash or sell out positions you currently own in order to satisfy the call. If you can't cover the call, your broker will liquidate your positions to get it covered.
If your broker starts selling out your positions, that broker doesn't care about your tax situation, your view of the company's long-term prospects, or anything else other than satisfying the call. If the market really moves against you -- say the company whose stock you bought on margin declared bankruptcy and the stock became worth $0 -- you're still on the hook for your borrowed funds.
Why buying on margin is a bad idea
Short-term movements in the market are almost impossible to predict, and there's always the risk of a black swan event like the coronavirus pandemic crashing the market. While the upside of margin trading may seem appealing, the downside risk is much greater.
As an investor, you have no control over the timing of a margin call, and you can fall victim to one even if it's just from a short-term movement. Even if you still believe that a stock will recover, and it does, you could still be forced to liquidate, meaning you missed out on gains you would have gotten if you were using an ordinary cash account.
Additionally, the interest payments and maintenance requirements add other costs and risks. Especially for beginning investors, it's best to avoid trading on margin since it's not always clear how much you've borrowed from your brokerage and how much you have in equity, plus it's easy to think of all of your holdings as your money even if much of it is borrowed. Remember that it's beneficial to your broker for you to use a margin account since it's an easy way for them to make money, so it's in their interest to encourage you to do so.
The recent events with WallStreetBet stocks like GameStop (NYSE:GME) offer the best argument for not using margins. It's easy to get sucked into such trades when the stock is skyrocketing, but GameStop just as quickly reversed, leaving thousands of traders facing a dreaded margin call.
Related investing topics
What's the difference between margin trading and short selling?
There are some similarities between margin trading and short selling since both involve additional risks. However, the mechanics of short selling are much different from margin trading.
Short selling means borrowing shares from your brokerage with the intent of buying them back at a lower price. That strategy works when the share price falls, but it can easily backfire. If the stock goes up, you lose money, and, unlike owning a stock, your losses are theoretically unlimited.
In this sense, short selling is even riskier than margin trading because you can be on the hook for an unlimited amount of money. With margin trading, you're only at risk of losing what you've invested and borrowed. Like margin trading, short selling generally requires traders to put up collateral, and a short seller can also be subject to a margin call forcing them to close out their bet.
What margin trading does have in common with short selling is that it should only be considered by very experienced investors who fully recognize the risks. Even then, those investors who want to use them should carefully limit their total exposure so that, when the market moves against them, it doesn't jeopardize the rest of their financial position.
While margin trading can be advantageous at times, overall the risks of borrowing from your brokerage outweigh the benefits.
Margin trading is risky since the margin loan needs to be repaid to the broker regardless of whether the investment has a gain or loss. Buying on margin can magnify gains, but leverage can also exacerbate losses.How much margin is enough? ›
But in general, a healthy profit margin for a small business tends to range anywhere between 7% to 10%. Keep in mind, though, that certain businesses may see lower margins, such as retail or food-related companies. That's because they tend to have higher overhead costs.What is a good margin for stocks? ›
Generally, a 10% net profit margin is considered okay, and anything below that could use improvement. Meanwhile, 20% is considered quite good, and anything higher is great.Where to invest to get 10 percent return? ›
- Invest in stocks for the short term. ...
- Real estate. ...
- Investing in fine art. ...
- Starting your own business. ...
- Investing in wine. ...
- Peer-to-peer lending. ...
- Invest in REITs. ...
- Invest in gold, silver, and other precious metals.
While margin loans can be useful and convenient, they are by no means risk free. Margin borrowing comes with all the hazards that accompany any type of debt — including interest payments and reduced flexibility for future income. The primary dangers of trading on margin are leverage risk and margin call risk.Is margin good for long term investing? ›
Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on. Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater the return that is needed to break even.What is a healthy margin? ›
As a rule of thumb, 5% is a low margin, 10% is a healthy margin, and 20% is a high margin. But a one-size-fits-all approach isn't the best way to set goals for your business profitability.What percentage of margin is safe? ›
Generally, the majority of value investors will NOT invest in a security unless the MOS is calculated to be around ~20-30%. If the hurdle is set at 20%, the investor will only purchase a security if the current share price is 20% below the intrinsic value based on their valuation.Is 10% a good margin? ›
A good margin will vary considerably by industry and size of business, but as a general rule of thumb, a 10% net profit margin is considered average, a 20% margin is considered high (or “good”), and a 5% margin is low.Is 30% profit margin too high? ›
With a net profit profit margin above 30%, your business is incredibly efficient at generating sales while keeping all expenses low. Nicely done!
What is a good gross profit margin ratio? On the face of it, a gross profit margin ratio of 50 to 70% would be considered healthy, and it would be for many types of businesses, like retailers, restaurants, manufacturers and other producers of goods.Do you want a high or low margin? ›
Do You Want a High or Low Profit Margin? In all cases, high. A higher the number (compared to the company's industry standard), the more confidence investors will have because the number is a direct reflection of how the business is being operated and expenses are being managed.What is the safest investment with highest return? ›
High-quality bonds and fixed-indexed annuities are often considered the safest investments with the highest returns. However, there are many different types of bond funds and annuities, each with risks and rewards. For example, government bonds are generally more stable than corporate bonds based on past performance.What is the safest thing to invest in right now? ›
- Treasury Inflation-Protected Securities (TIPS) ...
- Fixed Annuities. ...
- High-Yield Savings Accounts. ...
- Certificates of Deposit (CDs) Risk level: Very low. ...
- Money Market Mutual Funds. Risk level: Low. ...
- Investment-Grade Corporate Bonds. Risk level: Moderate. ...
- Preferred Stocks. Risk Level: Moderate. ...
- Dividend Aristocrats. Risk level: Moderate.
“U.S Treasury securities are considered the safest investment option, as they are backed by the full faith and credit of the U.S government. These investments come in several forms such as savings bonds, treasury notes, treasury bills, and more,” Chavez said.Why is buying stocks on margin not a good idea? ›
"Margin is a double-edged sword because stocks don't always increase in value. It's great when stocks go up, but it also magnifies investment losses when stocks decline. If a stock you purchase on margin declines in value you may be required to deposit additional funds in your account to cover the losses.Why is buying on margin a good idea? ›
You'll have more buying power
Margin investing allows you to have more assets available in your account to buy marginable securities. Your buying power consists of your money available to trade in your account, plus the amount that can be borrowed against securities held in your margin account.
If the security loses value, the losses will be deducted from your account value—not the funds you borrowed—so it's possible for margin to amplify your losses. Margin investing is risky and it's not appropriate for everyone.What are the pros and cons of margin? ›
|It can help finance the purchase of promising stocks.||Not all stocks qualify for margin buying. It depends on the performance.|
|Investors can capitalize on the leverage.||Investors have to maintain a minimum margin. Further, they have to pay at least 50%.|