Summary List Placement
Borrowing money increases buying power — that’s how you purchase a house or other big-ticket items you can’t afford outright. But did you know that you can do that with stocks, too?
It turns out that many investors can. Depending on your brokerage account type and balance, you may have the ability to do margin trading — or leverage your capital, as the pros call it.
But even if you are able to, is it a good idea to use borrowed money to invest in stocks? And do the advantages outweigh the risks? Here’s what you should know before testing the waters with margin trading.
What is margin trading and how does it work?
Margin trading, aka buying on margin, is the practice of borrowing money from your stock broker to buy stocks, bonds, ETFs, or other market securities. When you buy any of these investments on margin, the investment itself is used as collateral for the loan. By trading on margin, investors can increase their buying power by up to 100%.
Here’s how it works: Let’s say that you decide to buy $10,000 worth of XYZ stock. You pay $5,000 in cash and borrow — buy on margin — the other $5,000. Now imagine that your investment grows by 25% to $12,500. In this example, your actual return on investment would be 50%, since your cash outlay was only $5,000.
The example above may sound pretty great. But keep in mind that margin trading amplifies losses just as it does for profits. If your $10,000 investment decreased by 25% to $7,500, you’d effectively lose 50% on the trade.
It’s also important to keep in mind that brokers don’t lend margin funds for free. Like other loans, margin loans are charged interest. Margin rates are generally lower than the annual percentage rates (APR) of personal loans and credit cards, though, and there is typically no set repayment timetable.
Since margin positions are often held for relatively short periods of time, interest charges are typically reasonable. However, the longer your margin loan remains unpaid, the more you’ll want to consider how interest costs could impact your returns.
Advantages of margin trading
While it may seem that margin trading means bigger profits, that’s not technically true. If a $50,000 stock investment grows by 10%, your profit will be $5,000 regardless of whether you bought that stock with cash only or a combination of cash and margin.
In fact, you’ll have slightly less money at the end than if you had bought the stock outright since you’ll have to pay interest on the borrowed amount.
But margin trading does allow for a better percentage return. It also:
Increases your buying power: Margin trading enables you to invest more than you otherwise could. For stocks with very high share prices, using margin may be the only way to invest in them at all.
Enhances your ability to diversify: Using just cash, you might be able to invest in two or …read more
Source:: Business Insider