Buying on Margin

If you have a brokerage account, you can borrow against the value of your stocks and bonds to purchase additional investments. If you choose to do this, you are gambling with borrowed money.

Here are some examples from Margin: How Does It Work? by Rande Spiegelman, Vice President of Financial Planning, Schwab Center for Financial Research.

If you have $5,000 you can buy 100 shares of a stock that sells for $50.00 a share. If you then choose to borrow $5,000 from your brokerage firm you can buy an additional 100 shares. If the value of the stock increases to $70.00 a share and you then sell the stock you have made $2,000 on your initial investment, plus another $2,000 on the shares bought on margin (with borrowed money). Of course you have to pay back the $5,000 loan with interest, in this example $400. This leaves you with a profit of $3,600 using margin Vs a profit of $2,000 using only your money.

What happens if the trade goes wrong?

If you have $5,000 you can buy 100 shares of a stock that sells for $50.00 a share. If you then choose to borrow $5,000 from your brokerage firm you can buy an additional 100 shares. If the value of the stock drops to $30.00 a share and you then sell the stock you have lost $2,000 on your initial investment, plus another $2,000 on the shares bought on margin (with borrowed money). Of course you still have to pay back the $5,000 loan with interest, in this example $400. This leaves you with a loss of $4,400 using margin Vs a loss of $2,000 using only your money.

That is a loss of $4,400 out of your original $5,000. Pretty bad. That is the danger of buying on margin.

There is something else to worry about when using margin, the dreaded margin call. Often when you see a sharp drop in the market, prices continue to fall as investors using margin have to sell shares at distressed prices to get enough money to cover their margin requirements, usually around 30%.

Once again you have bought 200 shares of a stock at $50.00 a share using $5,000 worth of margin. If the value of your shares falls to $60.00 a share, you only have $1,000 in equity left in that position. Since $1,000 divided by $6,000 is a little less than 17%, your brokerage firm is going to ask you to come up with another $800 in cash right quick to meet their margin requirement of 30%. $1,800 divided by $6,000 is 30%.

From the article:

“Your brokerage firm may initiate the sale of any securities in you account without contacting you to meet margin call.”

“Your brokerage firm may increase it “house” maintenance margin requirements at any time and is not required to provide you with advance written notice.”

“You are not entitled to an extension of time on a margin call.”

“In fact, in a worst-case scenario it's possible that your brokerage firm will sell all your shares, leaving you with no shares yet still owing money.”

You should not be surprised to learn that I would never recommend the use of borrowed money to buy an investment that may decline in value. A house is different. You have to live somewhere. A house is both an investment and a necessary living expense. Margin caused the crash of 1929, a world wide depression, and was one of many causes that triggered World War II.

I am not going to play the market with borrowed money. Period.