Sooner or later many investors come across the concept of buying on margin, or using borrowed money to purchase more on stock trading to get extra oomph in their portfolio. But new stock trading investors should think twice before taking the plunge.
Brokers in stock trading are only too happy to lend you money to buy stocks and bonds if you open a margin account. You have to put up only part of the securities' price, and your broker lends you the rest. You just sign a couple of forms, and your broker runs a routine credit check on you. Brokers are eager to approve your application because margin accounts lead to more business and higher profits for them.
You can come out ahead in rising markets because you put up only 50 percent of the cost of your stocks and 25 percent of the cost of your bonds. So your money works at least twice as hard for you. The interest that you pay on your margin loan is not only relatively low but is also deductible from your taxable income up to the amount of your net investment income for the year.
Consider this scenario: It's late October 1998. After a sharp downturn over the past several months, the market has turned up. You find a stock you like. It's speculative, but you're willing to take the risk. The name is eBay. It's part of the red-hot Internet group in which Amazon.com and Yahoo! are doing so well. You have $10,000 to invest in your margin account. The quote on eBay is 50. With margin you can borrow money from your broker to buy additional eBay shares. Using 100 percent of your margin capability, you have buying power of $20,000-$ 10,000 of your money and $10,000 from the broker.
You buy $20,000 of eBay and get 400 shares. The price of eBay's stock soars to 733/8 the next day, and it's off to the races. The price skyrockets to 234 by November 24. You cash out, selling 400 shares and getting back $93,600. By using margin, your profit is $73,600 ($93,600 minus $10,000 of your capital and $10,000 to pay back the loan). If you hadn't used margin, your profit would only be $36,800.
Sound easy? Maybe too easy. You look brilliant. But wait a minute. New investors must be careful when borrowing money from a brokerage and using it to buy additional stock. It's a two-edged sword. If the price of the stock were to go down, the invested money would decline twice as fast. In the stock market crash of 1987, many stocks fell 40 percent or more in just a few days. Any account margined to the hilt suffered horrendous losses.
Margin isn't free: You pay interest on the borrowed money. The rate is marked up from the broker loan rate. A typical interest rate charged in early 1999 was 9.75 percent on a loan of less than $50,000. For larger loans the rate may be as much as two percentage points less.
It's wise not to venture out on margin until you've made several profitable trades. The best time to use margin is during the early phase of a new bull market. Once you recognize a new bear market, though, you should get off margin immediately and raise cash. An account should not be fully margined all the time. When progress is being made during a bull market, heavy margin can be used.
But when a correction sets in you should reduce your margin by selling shares. It's important to remember that it is a market of stocks, not a stock market. You must watch your stock positions and respond accordingly. Don't take solace in the general market averages. During the market retreat that occurred in 1998, many stocks turned lower well before the Dow Industrials revealed serious weakness in July and August.
If your stock trading rises-great! If it rises enough, you could sell some shares, pay off the margin loan and come out ahead. But if the gains in your stock don't cover your interest payments, you lose money. And if the stock price falls, you could suffer in two ways. Not only would your investment dwindle, but you could receive a call from your broker-a so-called margin call-to put up more cash.
A margin call occurs when the value of your collateral falls below a certain percent of your total purchase price-usually 30 to 35 percent. If the worth of your holdings drops under that level, your broker will demand that you deliver enough cash or other securities to bring your collateral back up to the required amount. If you can't deliver sometimes by the next day-the broker will sell your stock, take back what was lent you, and collect interest.
Before you decide to borrow on margin, ask yourself this key question: "Do I believe in the shares so wholeheartedly that I would be willing to borrow money even from a bank in order to own them?" If not, a margin account is not for you. If you do invest on margin, keep a close eye on your stocks. Check the prices often. You don't want a margin call to take you by surprise.
- By Alan Serling
For more information on using margin when investing in stocks visit About Investing Info.