Margin Trading - Crazy Risks, Crazy Rewards

© Copyright D. Alan Carter 
/ All Rights Reserved

If you've ever taken out a loan, you've already received a glancing education in trading on margin. Margin trading, in it's simplest terms, is trading with borrowed capital. The lender in this case is your broker. You are, in effect, borrowing money from your broker to buy stocks. As with any cautious lender, there will be a demand for collateral. In this case, the collateral on this loan from your broker is the investment you make (i.e., the stocks you purchase) with that money, as well as any additional funds or stocks in your account. And there's interest. And there's risks.

"Why do people buy stocks on margin?" "Is this something that can benefit me?" Let's find out.

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Margin Trading - Crazy Rewards, or just Crazy?Margin Trading - Why People Buy Stocks On Margin

Margin trading gives you financial leverage. In simplest terms, financial leverage is combining a little bit of your money with a little or a lot of someone else's money, enabling you to control a larger share of something than you would have been able to control otherwise.

In practical terms, let's say you want to buy 500 shares of SkyHigh Sausage currently trading for $10.00 per share. You're therefore looking to make a $5000 trade. Margin trading lets you contribute $2500 of your own money toward that goal, while borrowing the remaining $2500 from your broker to complete the trade. The end result - you fully own and control 100% of the 500 shares of SkyHigh, while only having had to put up 50% of the cost.

Now, your broker isn't doing this out of the goodness of his heart. Rest assured that he expects to profit. He'll do so by charging interest on the amount borrowed, called margin interest. Any gain attributed to a rise in the stock's price is yours to keep--assuming you sell, and after paying back the amount loaned and any margin interest.

So, why do people buy stocks on margin? Because margin trading amplifies any gain. Let's look again at our SkyHigh example. Let's assume the stock price goes up next week from $10 per share to $12. That's a $1000 or 20% gain. Had you used entirely your money to purchase your 500 shares, your investment gain would be just that - $1000 or 20%. Not bad.

But, going back to our example, because half the purchase price was paid for with someone else's money, your investment gain would be $1000 or 40%. Why 40%? Because your contribution for the stock was only $2500, not the $5000 it would be if you had purchased the stock entirely with your own funds. Subtracting of course the margin interest you would owe to your broker, you've just benefited dramatically by using OPM (other people's money). Every share enjoys the gain, but because the loan amount with your broker doesn't change, those gains are all yours because you own the controlling interest in those 500 shares.

Margin Trading - What's The Risk?

Well, margin trading is a two-edged sword. While margin trading amplifies any gain, it also exacerbates any loss.

Let's look again at our SkyHigh example. Let's assume you held the stock, and the stock price falls the following week from that high of $12 per share to $8, taking you down with the ride. Now, rather than a gain, you're facing a loss of a $1000 (or a 20% decline in the price you paid - $10). Had you used entirely your money to purchase your 500 shares, your investment loss would be just that - 20%.  

But, going back to our example, half the purchase price was paid for with someone else's money, your broker's money, and the margin agreement you will have signed with that broker specifies that his loan amount doesn't change. That means any losses are suffered from your share of the investment, not his. Your $2500 investment must bear the brunt of the downturn in stock price -- for all 500 shares. Were you to sell at this price, you would immediately pay back the broker his $2500 plus interest, leaving you with $1500, more or less. You'd lose $1000 on your $2500 investment for a return of negative 40%.

 Margin Trading - Is It Right For You?

Margin trading is scary stuff and not suitable for every investor's temperament. There is no single rule of thumb to gauge whether or not you should trade on margin. Except perhaps the following: trade on margin no more money than you would be comfortable losing. And to safeguard against those losses, there are trading techniques that can be helpful (i.e. stop-loss orders to limit your risk).

Once a decision is made to set up a margin account, a risk/reward analysis should be undertaken before placing any margin trade. In general, if there is a significant trend in the favor of your trade with a particular stock pick, you might consider using some of your margin buying power. On the other hand, in cases where the trend is against you or the outcome of a trade less certain, you'd be wise to limit your margin exposure.

Margin Trading - Tips and Advice

Remember, your broker is making money off margin trading by changing interest on the loans he makes to investors. That margin interest begins to accrue once a security is purchased, and will continue piling up until that security is sold. That being the case, the longer the investor holds a stock, the greater the return that is needed in order to break even. Hence, most savvy investors/traders consider margin trading a tool for short term investments. The longer you hold open a margin trade, the less likely a profitable outcome.

For additional information on margin trading: 
U.S. Securities and Exchange Commission - "Margin: Borrowing Money To Pay For Stocks" 
Wikipedia - Margin Buying

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