Buying on Margin

If you are interested in stock investments, you would certainly be on a look out for more lucrative investment options. Buying on margin is one such stock investment option that offers juicy returns on your initial investment. Buying on margin definition as given by investopedia is "the purchase of stocks by paying the margin and borrowing the balance from a bank or broker." This investment option is often considered as risky, since the fate of your investment greatly depends upon the condition of the stock market. Albeit, there is always risk involved with any stock investing. Buying on margin is particularly risky, as you owe a large sum to a broker.

What Exactly is Buying on Margin

Buying on margin simply means borrowing money from a broker to purchase stock. This technique allows you to purchase more stocks than you would normally do. You only invest half the value of stocks while your broker lends you the remaining half. This way you can purchase double the stocks than you can afford. For this type of transaction you first need to open a margin account with your broker. You need to deposit at least US$ 2000 in your account at the time of opening. This amount may vary as per the broker's requirements. When you sell stocks, you get to keep the profit on the stocks, while the amount borrowed from the broker has to be returned with due interest. This indeed sounds like a very promising investment option. However, there are certain risks involved in this type of stock investment, which we will see later. Let us take an example to understand how this whole thing works.

Buying on Margin Example

Let us assume you intend to buy 100 shares of a certain company, XYZ Inc. If each share costs you about US$ 10, then you would be required to invest US$ 1000 initially (100 x 10). We are ignoring the commissions for the time being. Suppose the value of each share reaches US$ 12 after you buy them, you get a profit of about US$ 200 upon your initial investment (100 shares x US$ 2 per share). This is about 20% of the total investment (200/1000).

Now let us say, you did not buy stocks by investing the initial amount all by yourself. You invested US$ 500 from your own pocket and borrowed the remaining US$ 500 from a broker. In this case, when the price of share shoots up to US$ 12, you still get a profit of US$ 200. However, this time your profit doubles up to 40% (200/500), since we are calculating profit upon your own investment. This is indeed a profitable situation even after you pay US$ 500 to the broker along with the interest.

The above example illustrated how buying on margin can promise you attractive returns. However, the tables can turn if the share price plummets. Let us continue with the same example as above. Suppose after buying shares on margin, the price of shares goes down to US$ 8, then suddenly you have to endure a loss of 40%. The situation can turn ugly if the share price plummets further. In worst cases, you might even have to face a 'margin call' in which your broker asks you to contribute more to your account or sell some of your stocks. Unfortunately, this is not the right time to sell stocks and thus, results in even more loss to you.

Thus, buying on margin can be an option, only if you are willing to take the risks that come with it. It is wise to invest only a small part of your income in such investment, so that repayment becomes easy.