In theory, buying stock on margin sounds like a great way to get rich quick. Buying on margin allows investors to “borrow” stock, with their brokerage effectively lending them the money to invest more heavily. However, like any type of credit, buying on margin can be a dangerous practice.
Buying Stock on Margin
As illustrated in the image above, think of buying stock on margin as a transaction on your credit card. You don’t have the money, but your credit card company is willing to pay for the purchase initially, and you will pay the bill later. Buying stock on margin allows investors to buy more stock than they actually have the money to pay for. Sure, you can hope that your stock will increase so much in value that it will cover the investment, but the stock market is anything but a sure bet. Buying stock on margin, or basically investing with your broker’s money allows you to gain more leverage, however any gains or losses have a greater impact on your portfolio than they otherwise would.
In order to open a margin account, the investor must deposit the margin amount into their account. This is the amount that the brokerage will use to determine how much credit they can advance to the investor. Margin purchases are secured by collateral such as cash or other securities. To use an extremely small amount as an example, if an investor deposited $100 into their account, buying stock on margin that is valued at $100 per unit, their brokerage might purchase 9 additional units on their behalf, for $900. The total investment becomes $1000. In this case, the investor used $900 in other shares from their portfolio as collateral for the additional units. If the investor’s stock drops in value, they must deposit more money to cover what has become a debt to their brokerage or lose the stocks they had put up as collateral.
If the stock in this case rose to $200 a share, the investor’s shares would now be worth $2000, allowing them to pay back the brokerage and still make a profit. However, the risk involved in this type of investment is simply too much for some investors to stomach. Looking at the situation conversely, if the company folded and the stocks lost all of their value, the investor would not only be out their initial $100, but owe the brokerage $900 as well. This makes buying stock on margin potentially very profitable, or very costly.
If an investor is unable to pay the debt in cash, the securities that they used as collateral may be sold off for less than they are actually worth as the brokerage attempts in any way possible to recoup their losses. Considering that the borrowed amount is also subject to interest, buying stock on margin is not the best investment tactic.
Some investors blindly walk into this type of arrangement without understanding how it works; anyone considering buying stock on margin must know the interest they will pay on the borrowed amount, the penalties they may incur if they default on the loan and the manner in which their collateral will be processed if their account is not in good standing. That’s why I call these accounts margarine accounts, because the brokerage house sure does get fat off of them.