Buying on margin can be a very effective way to leverage your money in the stock market. Let me ask you something. If you wanted to make $100 in the stock, would it be easier to make $100 from $500 or $1000? $1000 of course.
If you make $100 from $500 that is a 20% increase. That may be a little hard to pull off in 1 month. But if you make $100 from $1000 that is only a 10% increase in a month. Now I’m sure you all realize that the more money you have in the market the more you can pull out. So let me give you an example on how margin does just that.
Tom wants to buy stock ABC. It is a good stock that he believes will go up. The stock is currently trading at $85. He buys 100 shares of ABC. 2 years go by and ABC is trading at $170. Tom is excited and sells his stock. This gives him a 100% increase in 2 years.
In this example Tom made a good profit of his investment. But there is a way in which Tom could have made even more money. What is it?
It involves borrowing money. If Tom not only bought 100 shares of ABC, for $8500, but also borrowed an additional $8500 what would have happened. Well when the stock went up to $170 because he owned 200 shares he would have had $34,000. After he paid the money back Tom would have had $25,500. This would have given Tom a 200% return on his money.
How can Tom do this? Well Tom’s broker has a lot of money. The broker doesn’t mind loaning Tom some money to make a few trades. In fact Tom’s broker will loan him 100% of his account value.
Now there are a few bad things that can happen. Because when you buy on margin it is a loan you will have to pay some interest on it. Tom borrowed $8500 and maybe paid back $9000. Tom paid back so much because he held the stock for so long. If he had only held the stock for a few month he might have paid back only $8600. Every broker has a different interest rate they charge. To find out what your broker charges you can always call them up and ask.
Worst than the fee’s you might pay for buying on margin are margin calls. If Tom’s stock had gone from $85 to $50 his broker would worry and for a good reason. If Tom doesn’t have any money than he can’t possibly afford to pay them back. At this point your broker may call you up and tell you to sell your stock within a couple days. Tom would have had to sell his stock for $40, took a loss, and most of what he had would have had left would have gone to the broker, Owe.
There are a few things you can do to prevent margin calls.
1 You can watch your stock. Don’t let your stock go from $85 to $50 in the first place. If it starts to head down it would be better to get out at a small loss than to accumulate a bigger one, especially if you bought the stock with margin.
2 Put more money into your account. If your stock starts to fall and you still like it in the long term. You can always put more money into your account to pay your broker if he starts to get nervous.
3 Don’t buy on margin. If you want to invest in the long term and don’t want to take the chance that you might get a margin call, don’t borrow money. It is as simple as that. You can still make money without it.
Buying on margin can be a very effective way to leverage your money. I still borrow money every time I make a trade. It can help small profits become big profits. If you don’t know if it is right for you maybe paper trade with it. Just to get used to it. You never know if it works well for you until you try.
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