Borrowing to buy
Does margin investing suit your financial objectives?Margin refers to the amount of money that an investor must put up in order to purchase a particular stock. When you make a stock purchase, you may often borrow a portion of the purchase cost from your broker. The amount you’re allowed to borrow depends largely on the price of the shares and the volatility of those shares.
As well as setting margin requirements, the securities industry’s self-regulatory organizations set the guidelines for which stocks are marginable. Share price is a key factor in determining whether a particular stock qualifies for margin.
The interest rate charged by your broker on the loan is usually just above the prime borrowing rate. An advantage to buying on margin is that these borrowing or interest charges are considered carrying costs and are deductible for tax purposes. When you buy on margin, you are counting on the increase in the value in the stock to exceed the loan charges.
The major potential benefit of using margin is obvious: If the price of the stock goes up, your profit will be greater because you’ve used less capital than you would have if yo#8217;d paid for the whole thing. This strategy is known as “leverage”.
However, the flip side – the danger of margin investing — is that your risk of loss is also amplified through the use of leverage. Here’s how:
Remember that the brokerage firm has creditor rights and holds your shares as security for the loan. Your broker’s compliance department monitors your margin account and you’re required to maintain an agreed-on ratio of the loan amount to the price of the stock. If the loan value of the securities you own falls below the amount you borrow to purchase these securities, then a “margin call” will be issued to make up the difference.
Whether the drop in price is part of a general market downturn or just a decline in your particular stock holding, the demand calls for you to act immediately. So, even when you believe a market downturn will be relatively short-lived, if you don’t have cash to cover the margin call during the decline, your holdings could be sold off in order to maintain the loan ratio. This can be disastrous if prices are low and you’re using margin heavily.
It’s easy to see why margin calls have been the ruin of many investors during some of the major market corrections of recent years. Moreover, the sell-offs that result from margin calls have themselves been implicated by some industry analysts as being responsible for the severity of these market downturns.
If you’re considering using margin, it’s important to carefully weigh the advantages and the disadvantages of borrowing as part of your overall investment strategy. As with any investment decision, the amount you borrow must be in line with your tolerance for risk. In addition, it’s important to ensure that the stock itself is suitable for your overall investment objectives.