Money Sundays: Beware Buying Stocks on Margin

Readers: I originally wrote this post for a now-defunct website. I thought I’d share the insights here at Casual Kitchen for those readers interested in investing and personal finance.

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Margin buying is a tool that both individual and professional investors can use to boost their returns. However it can be a risky tool, and if overused, margin debt can be disastrous.

First you need to set up what's called a "margin account" with your broker. Usually these types of brokerage accounts will have minimum capital requirements, in some cases as much as US$25,000.

Let's go through a simple example of how margin borrowing works. First let's say you want to buy stock in XYZ company, which trades for $100 a share. You have enough capital in the account to buy 250 shares already ($100 x 250 = $25,000). But let's say you would like to buy MORE stock than that. With a margin account, you can borrow money from your broker to fund the purchase. This is called "buying stock on margin."

The "initial margin" required for a margin account purchase is 50%. Thus the broker will loan you funds for your investment, but you must have initial collateral in the account to equal half of the stock you want to buy. Thus a $25,000 margin account balance can theoretically give you "buying power" for $50,000 worth of stock. In return for this, the broker will charge you margin interest rates on your loan balance. Generally, margin interest rates range from 8-10%.

Let's look at an example of how using margin affects your returns. First we'll take a best-case scenario where the stock actually goes up. Let's say XYZ stock goes from $100 a share to $120 a share over the course of one year. If you had bought the stock with only your own money, your $25,000 in capital would have grown to $30,00 (250 shares x $120 per share), or a profit of $5,000 on your $25,000 initial investment. Congratulations, you just earned 20%!

But what if instead you had maxed out your margin account and bought $50,000 in XYZ stock?

First, you would have purchased 500 shares of XYZ stock at $100, using $25,000 of your own money and $25,000 of the broker's money.

After a year, when the stock was at $120 per share, you would have 500 shares XYZ at $120, or $60,000. Then you would need to subtract out $2,250 in margin interest expense (I'm assuming the broker charges you 9% interest for the margin borrowing). This leaves you with $57,750 in capital. Again, recall that you have invested $25,000 and you have borrowed $25,000 from the broker to make the initial $50,000 investment.

Let's assume you sell the stock now, and return the $25,000 to the broker. You've earned $7,750 ($60,000 minus $2,250 in interest expense, minus the $25,000 you borrowed from the broker) on your initial personal capital of $25,000. Congratulations even more! In this example you've earned 31% ($7,750 divided by $25,000). The extra borrowing power from the broker juiced your returns meaningfully, even after paying the added interest expense.

Sounds great, doesn't it? Well, like almost everything in investing, there is no free lunch. Stocks can go down too. For example, if XYZ stock that you bought in the margin example falls to $75 per share, your 500 shares will be worth only $37,500. But the problem is you still owe $25,000 to your broker. So that $12,500 loss ($50,000 minus $37,500) comes entirely out of YOUR pocket. Thus the $25,000 of your own money that you invested is now worth only $10,250, because you need to pay back the $25,000 to the broker AND pay the $2,250 in interest expense.

Thus with a 25% decline in the price of XYZ stock, you've lost 59% of your personal investment! And if-heaven forbid-the stock falls to $54.50, your investment will be totally wiped out after paying back the margin loan plus interest.

As they say on Wall Street, margin works both ways. It can eat you alive. When you use margin to buy stocks and they go down, your capital will be exposed to severe risk. Many investors learned this lesson the hard way during the 2000-2002 and the 2007-2009 market corrections.

Happy investing, and use margin with great care!