Margin is a tool that allows investors to potentially amplify their returns.
But there's no free lunch -- there are additional risks when using margin.
Here are some key things you need to know about buying stocks on margin.
When you open up a brokerage account, you will have the option of selecting what is known as a "margin account." Put simply, a margin account is one that allows you to borrow money from your broker to buy stocks using the assets that you already have in the account as collateral.
It's not hard to see how this could be useful. Let's say that you run across a really compelling investment opportunity that you don't think will last very long, but you're fully invested and it'll be a little while before you plan to add more funds to your account. Then using margin to take advantage of that opportunity might be a good idea.
However, investors -- especially those who are relatively new to investing -- should be extremely careful with margin and have a good understanding of the risks involved with using it.
Here, I'd like to offer some thoughts on the topic.
Margin Isn't Free
When you borrow money from a bank or hold a balance on a credit card, you pay interest on what you've borrowed -- that's why lenders bother to lend out money to begin with. Margin debt is no different. When you buy stocks on margin, you pay interest on your margin balance (known as the margin rate).
For example, Fidelity Investments charges a base margin rate of 8.075% with the effective rate varying with the size of the balance (the more you borrow in this case, the lower your effective rate is, although keep in mind that with higher overall balances the raw dollar amount that you pay in interest goes up).
What this means is that before buying stocks on margin, you should be confident that you are going to make more on that investment than what you'll end up paying in margin interest. For shorter-term/more opportunistic trades, margin can make a lot of sense -- if you buy a stock on margin that then appreciates 10% within a week, then you've made a great return.
For longer time horizons, it can get a little trickier. Let's say you borrow $10,000 to buy a stock that then proceeds to trade sideways for a year. If you weren't using margin, a stock trading sideways isn't great (there is opportunity cost as that money could have been invested in a stock that went up), but you're not really losing anything. By buying those stocks on margin, you've effectively suffered a loss equivalent to the interest that you've paid. Or, put another way, you need an even greater return on the shares that you bought on margin to actually make a profit than you would for shares bought with your own money.
No investment is without risk and because margin isn't free, using margin to buy stocks increases the risk that you're taking with a particular transaction.
Margin Investing Can Go Horribly Wrong
While the above discussion might make it seem as though the key risk with margin investing is simply the fact that margin costs money, the reality is that things can go south very quickly if you have significant margin debt and your portfolio takes a hit.
Remember that when you buy stocks on margin, you're using the value of the assets in your account as collateral. If the value of your assets drop dramatically (thanks to a market downturn or company-specific issues with the stock(s) that you own), then you're at risk of being forced to sell assets in your account or needing to deposit more money into your account to avoid those assets from being sold.
In this case, not only have you amplified your losses by buying stock on margin, but you might be forced to sell stocks/assets at a bad time as a result. Not only could this mean missing out on the upside that you could have enjoyed from those assets (assuming that they eventually went back up), but if you are forced to sell assets that you have capital gains on, you're going to be forced to pay taxes on those gains.
This is why -- unless you really know what you're doing and fully appreciate the risks involved -- if you're going to use margin, you shouldn't use all of the margin available to you.
Margin can be a powerful investing tool when used appropriately -- it can allow you to amplify your gains and/or take advantage of opportunities that arise in the short term that you otherwise might not have been able to without it. However, with great power comes great risk and responsibility, and without the proper understanding of the risks and the discipline to use it correctly, it has the potential to completely destroy your portfolio, costing you the money that you have likely worked so hard to put away.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The views expressed in this article are solely mine and do not represent those of my employer.