Buying stock on margin essentially means purchasing stocks with borrowed money from a brokerage firm. In other words, an investor opens a brokerage account (perhaps with an online broker) and borrows funds from their broker to buy securities.
Margin trading can allow you to increase your potential returns, as you can invest more money than you actually have. However, it also increases potential risks, as you are now exposed to not only the risks of the stock market, but also the risks associated with the borrowed funds.
When buying stock on margin, you must maintain a certain level of equity in your account, known as the margin requirement. If the value of the stocks held in your account falls below this margin requirement, you will receive a margin call and may be required to deposit additional funds to maintain the minimum equity level. If you fail to meet the margin call, the brokerage firm may sell your securities to cover the borrowed funds, which can result in significant losses.
Here are 6 tips to help you avoid a margin call:
- Understand the Margin Requirement: Make sure you understand the margin requirements of your broker and the securities you are trading. Different brokers may have different margin requirements, and they may vary depending on the type of securities being traded.
- Monitor Your Account: Keep a close eye on the value of the securities in your account and the amount of margin you are using. Regularly monitor your account and make adjustments as needed.
- Diversify Your Portfolio: Diversifying your portfolio can help reduce risk and minimize the likelihood of a margin call. Avoid overconcentration in a single security or sector.
- Don’t Overextend Yourself: Only borrow what you can afford to pay back. Avoid taking on too much debt or using too much leverage.
- Have a Plan: Develop a trading plan and stick to it. Don’t make impulsive trades or let emotions drive your investment decisions.
- Keep Cash on Hand: Maintain a cash reserve in your account to cover unexpected margin calls. This will help ensure that you have the funds you need to meet margin requirements and avoid forced selling of securities.
Remember, buying stocks on margin can be a risky strategy, and it’s important to fully understand the risks before using margin. If you’re unsure about margin trading or need guidance on managing your margin account, consider consulting with a Financial Advisor or a professional with expertise in margin trading.
Example of Potential Profits from Margin Trading
Let’s say you have $10,000 in cash and you want to buy 100 shares of a stock priced at $100 per share. If you buy the stock outright, you would spend $10,000 and own 100 shares.
However, if you buy the same 100 shares on margin with a 50% margin requirement, you would only need to put down $5,000 (50% of $10,000) and borrow the other $5,000 from your broker. If the stock price increases to $120 per share, you would sell your 100 shares for $12,000, resulting in a profit of $2,000 (20% return on your initial $10,000 investment).
But keep in mind that buying stocks on margin also increases your risk. If the stock price goes down instead of up, your losses will be amplified by the borrowed funds, and you could potentially receive a margin call if the value of your investment falls below the minimum margin requirement. An example of this scenario is discussed below.
Example of Potential Losses from Buying on Margin
Let’s say you have $10,000 in cash and you want to buy 100 shares of a stock priced at $100 per share. If you buy the stock outright, you would spend $10,000 and own 100 shares.
However, if you buy the same 100 shares on margin with a 50% margin requirement, you would only need to put down $5,000 (50% of $10,000) and borrow the other $5,000 from your broker. If the stock price decreases to $80 per share, you would sell your 100 shares for $8,000, resulting in a loss of $2,000 (20% loss on your initial $10,000 investment).
But since you borrowed $5,000 from your broker, you would still need to repay the loan with interest. Depending on the interest rate and the time frame, the interest charges could further increase your losses.
If the value of your investment falls below the minimum margin requirement, you could also receive a margin call and be required to deposit additional funds to maintain the minimum equity level. If you’re unable to meet the margin call, your broker could sell your securities to cover the borrowed funds, resulting in further losses.
Summary
Buying stocks on margin can be a risky strategy that involves borrowing funds from a broker to purchase securities. While it can increase potential returns, it also amplifies risks and potential losses. To avoid a margin call, you should understand your brokers margin requirements (including the specific security being traded), monitor your accounts, diversify your portfolio, avoid overextending yourself, have a plan, and keep cash on hand.
