Advantages of buying on margin

As a rule, I generally try to dissuade my clients, or anyone, from buying securities on margin (credit). The reason is that it’s just too risky, especially with the way the market has been behaving over the past two years. While I am not going into too much detail about buying on margin, I am saying this. When the market is gaining, buying on margin can be great. However, when the market starts to head south, buying on margin can kill you financially.

This is how margin works. Let’s say you have $200,000 that you want to invest. You would like to invest more money than that, but you only have the $200,000 available right now. You open an account with a brokerage firm, who then approves you for margin trading. (Not everyone can trade on margin—you really do have to be approved.) By law, the brokerage house can loan you up to 50 percent of the total purchase price for stocks. So, let’s assume that you would like to purchase a total of $300,000 of XYZ common stock. You invest your $200,000 and you purchase the remaining $100,000 on margin. The maximum margin amount for this example would be $200,000, making the total investment amount $400,000.) You now owe the brokerage house $100,000. They can, and will, charge you some form of interest on that balance. Make sure that if you do trade on margin, you know what kind of interest rates and payments are applicable.

After the initial purchase, you own $300,000 worth of XYZ common. Now, assuming the market goes up, your share increases, not the part you bought on margin. If the price doubles, your shares would be worth $600,000. Of that $600,000, your portion is worth $500,000. You still owe the house $100,000. At this point, you could sell $100,000 worth of stock, plus whatever amount was needed to satisfy the interest owed on the loan, and pay back your loan to the brokerage house to clear up your debt. Then, your portion would continue to go up and down with the market.

Your  share = $200,000
   Margin  purchase (loan) = $100,000
   Total  investment = $300,000
   Market  price doubles; account value = $600,000
   Your share = $500,000

Sounds great, right? Now let’s assume that the market goes down instead of up. Rather than your investment doubling in price, it’s now worth only 40 percent of what you paid, or $120,000. How much is your share worth now? A tidy $20,000. You still owe the house the whole $100,000. And if the price of the stock drops much more, the brokerage house will give you a call and ask you for its money. If the price drops substantially, they will sell off your position to satisfy as much of the loan as possible.

Your  share = $200,000
   Margin  purchase (loan) = $100,000
   Total  investment = $300,000
   Market  drops by 60%; investment worth = $120,000
   Your  share = $20,000
   Loan balance = $100,000

This is the risk of investing on margin. There are specific rules that govern margin accounts that spell out when the brokerage house can sell your securities and when they can ask for their money back because the market price for the security has dropped. If you have the cash to satisfy these margin calls and can pay off your debt with interest to the brokerage house, then you are in the clear. However, if you don’t, then you have to look at liquidating some of your other assets to cover the payment. Like I said, investing on margin is great when the market goes up. You purchase more securities with the money you borrow from the brokerage house, your investment goes up faster because you own more shares, the brokerage firm is making money off of you in the form of interest, and everyone is happy. However, it’s not so great when the market goes down. Unfortunately, no one knows what the market is going to do, which poses another risk to investing on margin.