The straightforward way to buy stocks is to transfer your own money to your self-directed investment account and use those funds to place an order. But what if you could increase your buying power by borrowing money to invest? It may sound like a great idea, but the significant risks involved in this investment approach (including the possibility of losing your investment entirely) mean it's not for everyone.
Margin trading 101
Margin trading occurs when you borrow money directly from your brokerage company to invest. The investments you hold in your investment account (called your margin account assets) are used as collateral for the loan. The brokerage company charges interest for the duration of the loan until you repay it at a later date.
Opening a margin account — what you need to know
In order to start trading on margin at Investor’s Edge, you'll first need to set up a non-registered investment account with a margin feature. This account will allow you to borrow money against the investments in your account or borrow to buy securities at a competitive interest rate.
Minimum investment amount
Before you can start trading, you'll be required to deposit a minimum amount. Investor's Edge margin account holders must maintain a minimum $2,000 equity balance to place a buy transaction using margin.
Maximum borrowing amount
The more qualifying assets you have in your account, the more you can borrow. Margin amounts vary depending on the type of investments you hold. While some stocks don't offer a right to credit or loan value — for example, stocks trading under $3 are not marginable — other securities may qualify for a loan as high as 70% of their current value. Your financial situation and the concentration of your portfolio will also determine your potential loan amount.
Interest charge
Just like any loan, you're required to pay interest on the money you borrow; the rate varies by brokerage firm and your account's debit balance (see Investor’s Edge current rates). Depending on your situation, interest on your loan may offset taxable income — be sure to talk to your tax advisor to see if this applies to you.
Margin call
While margin trading can allow you to buy more investments than you might otherwise be able to afford, you’ll face a margin call if the equity in your account declines below certain required levels. When this occurs, your brokerage will require you to deposit additional cash or securities to bring your investment up to the minimum required value.
Example
You own 1,000 shares of XYZ company in your account. Each share is currently $50, so the market value of the account is $50,000. Providing that the equity requirement is 30%, you must maintain $15,000 in equity in the account. If you have an outstanding margin loan against the securities of $40,000, your equity is $10,000 ($50,000 - $40,000 = $10,000) and the margin call will be $5,000 ($15,000 - $10,000 = $5,000).
If you can't deposit more cash or securities, your brokerage may sell your margin account assets, at its discretion, to cover the shortfall.
Benefits of opening a margin account
Opening and using a margin account has several advantages when it comes to increasing your investing potential.
Boost your returns through leverage
The major benefit of buying stocks on margin is the ability to amplify your buying power and allow you to buy more than you could with just your own funds. This could increase the size of your returns.
Let’s say you have 1,000 shares of XYZ company and would like to buy 500 more.
- Rather than use your own cash to buy the additional shares, you borrow $25,000 on margin, using your original 1,000 shares as collateral.
- You use these funds to buy 500 shares at $50 per share.
- If the price rises by $10, you sell the 500 shares and repay $25,000 plus an interest charge of $120.
Note: The interest amount of $120 is hypothetical and for illustration only.
- You realize a profit of $4,880:
$30,000 - $25,000 - $120 = $4,880.
Note: This example doesn’t include trading commissions.
Access to more sophisticated investment techniques
Some strategies (e.g., short selling and naked puts) can only be executed in a margin account. You can expand your investment opportunities by seeking approval to trade options in your margin account. Keep in mind, options are better suited for sophisticated investors who have both the skill and the time to monitor their accounts daily.
Risks of opening a margin account
Because you're leveraging your investments, you take on a number of significant risks when you use a margin account.
You can lose more than you invested
Compared to buying stocks with cash, you can potentially lose more money by using margin because you're buying with funds you don't have.
Let's say you buy 2,000 shares of XYZ company at $10 a share. You use $10,000 of your own funds and borrow $10,000 in your margin account — a total of $20,000 before commissions. A month later, the market corrects and your stock drops 50%. The result? An unrealized loss of all your own money, plus any commissions and interest.
Interest costs can really add up
Although most margin accounts don't set a repayment schedule, you'll need to stay on top of interest costs and pay them down regularly to avoid depleting the cash in your account. What's more, the interest rate you pay on the money you borrow isn't set and can change at any time, which means you may end up spending a great deal more than you expected when it comes time to repay the loan. At Investor’s Edge, we post the interest charges to your account at mid-month.
Margin strategies
If you've researched the additional risks involved in margin investing and have the time and attention to manage a margin account, be sure to start slowly by initially buying just one or two securities. Investing in just a few stocks allows you to experience risks and benefits on a smaller scale. Consider these tips.
Maintain a margin buffer in your account
Always have more than you need in your account to maintain the minimum account balance requirement. Consider leaving 10% buffer in your margin account to help manage the ups and downs of the stock market.
Track your trade status and monitor your holdings
Especially when markets are volatile.
Know when to get out
Consider using stop-limit orders to reduce potential losses on your investments.
Margin trading can be a useful and valuable tool to leverage your investments and increase potential returns. However, it comes with additional risk and requires prudent and disciplined management. Apply for an Investor's Edge non-registered account with a margin feature Opens in a pop-up. or add a margin feature to your existing Investor's Edge non-registered account by contacting us.
