If you invested $10,000 in a good stock and earned a 20 percent return, you would earn $2,000. But what if you could have borrowed another $10,000 to buy more shares and doubled your profits?
When investors borrow money or buy on margin, they go for these types of profits. But the strategy is extremely risky because while it increases your profits, it also increases your losses. Margin trading is said to have worked well in 2020 and 2023 as stocks soared after initial concerns about the pandemic subsided. But when the Federal Reserve raised rates in 2023 to combat inflation, those trading on margin likely suffered more than the average investor. Here’s what you need to know about buying stocks on margin.
How margin trading works
Buying on margin involves getting a loan from your broker and using the loan money to invest in more securities than you can buy with your available money. Margin purchasing allows investors to increase their returns, but only if their investments outperform the cost of the loan itself. Investors may lose money faster with margin loans than investing with cash.
This is why margin investing is usually best limited to professionals such as mutual fund and hedge fund managers. To make the biggest gains, some institutional investors invest more than the available money in their funds, thinking they can choose investments that provide returns greater than the cost of borrowing money.
“Margin is essentially a loan you take out to gain more influence over your investments,” says Steve Sanders, executive vice president of business development and marketing for Interactive Brokers Group.
The costs for the loans vary considerably, especially for investors with less than about $25,000 in their accounts. Margin loan interest rates for retail investors typically range from as little as 6 percent to more than 13 percent, depending on the broker. Because these rates are usually tied to the federal funds rate, the cost of a margin loan will vary over time.
Biggest risks of buying on margin
Buying on margin has a turbulent past. “During the crash of 1929, there was very little regulation of margin accounts, and that contributed to the crash that caused the Great Depression,” says Victor Ricciardi, a visiting professor of finance at Ursinus College.
You could lose more than your initial investment
The biggest risk of buying on margin is that you could lose much more money than you initially invested. A drop of 50 percent or more on stocks that are half-financed with borrowed money equates to a loss of 100 percent or more in your portfolio, plus interest and commissions.
For example, let’s say you buy 2,000 shares of company XYZ with $10,000 of your own cash plus $10,000 in your margin account at a cost of $10 per share. That’s a total of $20,000, excluding commissions. The following week, the company reports disappointing earnings and its stock falls 50 percent. The position is now worth $10,000, and you still owe that amount to the broker for the margin loan. In that scenario, you lose all your own money, plus interest and commissions.
There may be a margin call
In addition, the assets in your account must maintain a certain value, the so-called maintenance margin. If an account loses too much money due to underperforming investments, the broker will make a margin call, requiring you to deposit more money or sell some or all of the assets in your account to pay off the margin loan.
“If the markets or your overall positions fall, your broker can liquidate your account without your permission,” says Ricciardi. “That is an important downside risk.”
Even those who advocate buying on margin in some situations, despite the risk, warn that it can magnify losses and require a return higher than the margin lending rate.
“Margin trading is for experts who understand how it works – not for the average retiree,” says Ricciardi.
Key benefits of buying on margin
Of course, if an investment purchased on margin performs well, the profits can be richly rewarding.
Liquidity
In addition to using a margin loan to buy more shares than investors have money for in an investment account, there are other benefits. Margin accounts, for example, offer faster and easier liquidity.
“For most of our clients, we like to have a margin account, even if they never buy stocks on margin, because they can transfer funds more quickly,” said Tom Watts, chairman of Watts Capital Partners, a broker-dealer that provides financial services to clients offers.
For example, investors usually can’t withdraw cash from a stock sale until three days after the securities are sold, but a margin account allows investors to borrow money for three days while they wait for their trades to settle.
“With a margin account, they don’t have to wait: they have immediate access to cash,” says Watts. “You still have to pay interest on those three days, but that is minuscule.” For example, a $10,000 margin loan at 5 percent interest would incur interest costs of less than $2 per day.
Increases returns in bull markets
Watts says his more active clients use a margin account to borrow money to invest with, but he cautions that such an investment strategy is best left to a full-time trader.
“If you stand in front of your terminal every day, have strict loss limits and a trading mindset, margin investing can be a great thing in rising markets. But investors should only do this if the market continues to rise and apply very strict loss limits,” says Watts.
The problem is that we don’t know when the market might suddenly change course, he adds. “If you have a major disruptive event, prices can go against you quite quickly and you could end up owing a lot of money within a few days. Anyone investing on margin must monitor their portfolio closely every day.”
In short
Using borrowed money to invest can give a big boost to your returns, but it’s important to remember that leverage also amplifies negative returns. For most people, buying on margin makes no sense and carries too great a risk of permanent losses. It’s probably best to leave margin trading to the professionals.
