If you buy a house at a purchase price of $100,000 and put 10 percent down, your equity (the part you own) is $10,000, and you borrow the remaining $90,000 with a mortgage. If the value of the house rises to $120,000 and you sell, you will make a profit of 100 percent (closing costs excluded). How is that? The $20,000 gain on the property represents a gain of 20 percent on the purchase price of $100,000, but because your real investment is $10,000 (the down payment), your gain works out to 200 percent (a gain of $20,000 on your initial investment of $10,000).
Credit: ©iStockphoto.com/vaeenma
Buying on margin is an example of using leverage to maximize your gain when prices rise. Leverage is simply using borrowed money to increase your profit. This type of leverage is great in a favorable (bull) market, but it works against you in an unfavorable (bear) market.
Say that a $100,000 house you purchase with a $90,000 mortgage falls in value to $80,000 (and property values can decrease during economic hard times). Your outstanding debt of $90,000 exceeds the value of the property. Because you owe more than you own, it is negative net worth. Leverage is a double-edged sword.
Marginal outcomes
Suppose that you think that the stock for the company Mergatroid, Inc., currently at $40 per share, will go up in value. You want to buy 100 shares, but you have only $2,000. What can you do? If you're intent on buying 100 shares (versus simply buying the 50 shares that you have cash for), you can borrow the additional $2,000 from your broker on margin. If you do that, what are the potential outcomes?If the stock price goes up
This is the best outcome for you. If Mergatroid goes to $50 per share, your investment will be worth $5,000, and your outstanding margin loan will be $2,000. If you sell, the total proceeds will pay off the loan and leave you with $3,000. Because your initial investment was $2,000, your profit is a solid 50 percent because ultimately your $2,000 principal amount generated a $1,000 profit. However, if you pay the entire $4,000 upfront — without the margin loan — your $4,000 investment will generate a profit of $1,000, or 25 percent. Using margin, you will double the return on your money.Leverage, when used properly, is very profitable. However, it is still debt, so understand that you must pay it off eventually.
If the stock price fails to rise
If the stock goes nowhere, you still have to pay interest on that margin loan. If the stock pays dividends, this money can defray some of the cost of the margin loan. In other words, dividends can help you pay off what you borrow from the broker.Having the stock neither rise nor fall may seem like a neutral situation, but you pay interest on your margin loan with each passing day. For this reason, margin trading can be a good consideration for conservative investors if the stock pays a high dividend.
Many times, a high dividend from $5,000 worth of stock can exceed the margin interest you have to pay from the $2,500 (50 percent) you borrow from the broker to buy that stock.
If the stock price goes down, buying on margin can work against you. What if Mergatroid goes to $38 per share? The market value of 100 shares will be $3,800, but your equity will shrink to only $1,800 because you have to pay your $2,000 margin loan. You're not exactly looking at a disaster at this point, but you'd better be careful because the margin loan exceeds 50 percent of your stock investment.
If it goes any lower, you may get the dreaded margin call, when the broker actually contacts you to ask you to restore the ratio between the margin loan and the value of the securities.
Maintaining your balance
When you purchase stock on margin, you must maintain a balanced ratio of margin debt to equity of at least 50 percent. If the debt portion exceeds this limit, then you'll be required to restore that ratio by depositing either more stock or more cash into your brokerage account. The additional stock you deposit can be stock that's transferred from another account.If, for example, Mergatroid goes to $28 per share, the margin loan portion exceeds 50 percent of the equity value in that stock — in this case, because the market value of your stock is $2,800 but the margin loan is still at $2,000. The margin loan is a worrisome 71 percent of the market value ($2,000 divided by $2,800 = 71 percent). Expect to get a call from your broker to put more securities or cash into the account to restore the 50 percent balance.
If you can't come up with more stock, other securities, or cash, then the next step is to sell stock from the account and use the proceeds to pay off the margin loan. For you, it means realizing a capital loss — you lost money on your investment.
The Federal Reserve Board governs margin requirements for brokers with Regulation T. Discuss this rule with your broker to understand fully your (and the broker's) risks and obligations. Regulation T dictates the minimum percentage that margin should be set at. For most listed stocks, it is 50 percent.
Margin, as you can see, can escalate your profits on the upside but magnify your losses on the downside. If your stock plummets drastically, you can end up with a margin loan that exceeds the market value of the stock you used the loan to purchase. In the emerging bear market of 2000, many people were hurt by stock losses, and a large number of these losses were made worse because people didn't manage the responsibilities involved with margin trading.If you buy stock on margin, use a disciplined approach. Be extra careful when using leverage, such as a margin loan, because it can backfire. Keep the following points in mind:
Have ample reserves of cash or marginable securities in your account. Try to keep the margin ratio at 40 percent or less to minimize the chance of a margin call.
If you're a beginner, consider using margin to buy stock in large companies that have a relatively stable price and pay a good dividend. Some people buy income stocks that have dividend yields that exceed the margin interest rate, meaning that the stock ends up paying for its own margin loan. Just remember those stop orders.
Constantly monitor your stocks. If the market turns against you, the result will be especially painful if you use margin.
Have a payback plan for your margin debt. Margin loans against your investments mean that you're paying interest. Your ultimate goal is to make money, and paying interest eats into your profits.
