Pros and cons of margin trading

Margin trading lets investors buy stocks with borrowed money. Here's what you should know.

  • By John Divine,
  • U.S. News & World Report
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What is margin trading, and should you use it?

Well, there’s no one-size-fits-all recommendation, but a brief overview of what margin is, how you can use it, and the pros and cons of margin trading is worthwhile.

Margin, in the world of finance, is basically leverage. Technically, margin is money deposited with a broker as collateral for a cash loan. Investors can then use this borrowed money to magnify their portfolio returns. Investors engaging in margin trading can buy all sorts of financial instruments (stocks, exchange-traded funds, real estate investment trusts, mutual funds, etc.) with money that isn’t theirs.

Of course, money isn’t free, and the party a margin trader borrows from charges interest that the trader must eventually pay back. Liquid securities on hand can also be used for collateral in the account.

Despite this, interest rates can still be relatively high, and there are many other practical facets of investing on margin to consider before leaping in.

Pros of margin trading

It’s very unlikely the average citizen of a first-world country living in the 21st century will go their entire life without financing something with debt. In fact, millions of people prominently finance the largest purchases of their lives through debt – and these purchases are often thought of simultaneously as investments.

“Using margin to buy stocks is similar to using a mortgage to buy a house. In both instances, investors borrow money to purchase more equity in stocks or real estate,” says Ali Hashemian, president of Kinetic Financial.

In other words, anyone who has used or will use a mortgage to buy a property (usually expecting it to rise in value over time) is already familiar with the benefits of using margin to acquire an attractive asset.

Borrowing money to invest in any asset, be they stocks or houses, serves one primary purpose: magnifying the investor’s return, for better or worse.

Used cautiously, it can create enormous wealth.

A $300,000 house bought with $50,000 in cash and $250,000 borrowed from the bank will swiftly multiply the homeowner’s returns sixfold. A $50,000 increase in home value to $350,000 would’ve been just 16.7% gains had the house been fully paid for by the buyer. Instead, by putting together one-sixth the home value and borrowing the rest, that $50,000 is now $100,000 in equity, doubling his investment.

Cons of margin trading

Of course the juiced-up gains that come with margin-fueled bull runs are matched only in intensity by the catastrophic damages that even modest price declines can wreak upon anyone overleveraged and unlucky.

The dormant but catastrophic risks associated with using large amounts of borrowed money to buy stocks or other financial assets were on full display in the financial crisis of 2008-2009. Financial services giant Lehman Brothers actually went bankrupt in September 2008 and the cause of death was leverage.

Lehman had $680 billion in assets – mostly low-quality real estate holdings – and $22.5 billion in equity. A leverage ratio of 30-to-1 meant all it would take to make Lehman’s stock worth less than nothing was a 3% to 4% drop in its risky subprime holdings.

Warren Buffett, the greatest investor in the world, doesn’t use margin to amplify his returns. One shudders to think at how good his returns would be if he’d used some prudent margin here and there.

One notoriously bad thing that can happen to those using margin is the dreaded “margin call,” – your broker calls asking you to add more money to the account, or sell other shares into cash, once your so-called “maintenance margin” – a minimum percentage of equity investors must maintain in their margin trades – gets too low. The broker is allowed to sell other assets in your account, reduce your position, or sell out entirely and lock in substantial losses without permission if you can’t be reached.

“An investor might want to use margin to purchase more shares in a down market. The problem is that nobody can predict the bottom,” Hashemian says.

Where can you buy stocks on margin?

Despite its immense risk, you’d be hard-pressed to find a broker, full-service or online, that doesn’t allow margin trading. Charles Schwab, E-Trade, Fidelity, TD Ameritrade and many others allow customers to trade on margins.

It’s important to understand the finer points here, like your broker’s maintenance margin requirement, margin call procedures, what sorts of securities you can use margin on (e.g. often leveraged ETFs , options and other inherently high-risk assets don’t qualify.)

The best of the major online brokers for margin trading is probably Interactive Brokers (IBKR). It currently boasts far and away the lowest interest rate on margin loans at between 3% and 4%. Most other online brokers charge two or three times that rate, though rates vary by account size.

Should you buy stocks with borrowed money?

The short answer here is no, although it can be justified in certain situations.

First, if you’re the type of investor who just likes to mess around with a few bucks here and there, try something new, test some harebrained theory and see what happens – all while knowing the odds are against you – that’s what “play money” is for.

Just consider it lost and make sure you don’t need it before you start margin trading. And make sure you understand how to limit your losses – it’s possible to lose more than you initially invested.

Zaki Ahmed, a 29-year-old rideshare driver in Washington, D.C., and finance student with a background in film, trades currencies on the foreign exchange market. He uses a platform called OandA, which allows users to trade on margin.

“OandA recommends a moderate leverage amount of 20 to 1 or lower,” Ahmed says. “My leverage is almost 50 to 1.” One reason Ahmed isn’t losing sleep over that leverage ratio is that he only keeps a few bucks of his own money in the account at any given time. His account balance is usually less than $100.

Still, he keeps this low balance for a reason. Ahmed has been burnt repeatedly from making high-risk financial decisions.

“I’ve been through the ringer in terms of all manner of investment and gambling. To be honest, I regret that I’m doing this now. I won’t tell you how much I’ve lost but it’s in the thousands,” Ahmed says.

But the only time trading on margin is ever really justified as a financial move, not a lottery ticket, is when investors are able to take calculated risks in those rare times that opportunity knocks the loudest.

“This should be done when the expected return of the investment being made is greater than the cost of leverage,” says Jose Remy, a partner at Alvarium Investments, an independent international investment firm. “And when the risk profile of the investment and the client’s overall portfolio is commensurate with his or her risk tolerance,” Remy says.

Both bars must be met, in Remy’s view, before using margin to trade stocks should even be considered.

For investors looking to save for retirement or optimize the risk/return of their overall portfolio, they might as well forget about margin.

But for some, the rapid, unpredictable ups and downs aren’t much of a problem, just the name of the game.

Ahmed, when given the hypothetical option to shift the majority of his holdings into a vanilla, low-cost ETF that tracks a major stock-market benchmark, responded instantaneously.

“No,” Ahmed says. “Stocks aren’t volatile enough.”

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