One thing I have NEVER done is buy stocks on margin. For the same reason I have tried hard to stay out of debt, margin accounts can get you in all sorts of trouble and should be avoided by beginners. Why? Because while you can make money twice as fast, you can also lose it twice as fast and there is usually no reason to take the risk.
What Is A Margin Account?
A margin account is a special kind of account that allows you to borrow money from your broker in order to be able to increase your purchasing power. You have to specifically sign up for this type of account or have your current account changed to one.
Not everyone is accepted – you need an absolute minimum of $2,000 and many brokers require even more than that. You can sign up online with most brokers and will be notified in a day or two if you have been accepted for this type of account.
What Does Buying Stocks On Margin Mean?
It means your broker is loaning you money (the collateral is the money or stocks you already have in your account) so that you can buy more stock than you have the actual dollars to buy. You are going into debt and using that debt to buy stock. You will be charged interest on the money your broker loans you so it is NOT free.
For instance, if you have $50,000 in your account, you may be able to buy up to $100,000 worth of stock. The risks/rewards are obvious: if you have twice the number of shares of a stock you will make double the money if the stock goes up but lose twice as fast if the stock goes down. The longer you keep the shares of stock, the more interest you will owe as well.
The Danger Of Buying On Margin
When you buy on margin, your broker has control of the stocks you buy. You technically own them but your broker can at any time ask you for more money or sell those stocks if they start to go down. After all, your broker is loaning you money and is not going to be left holding the bag if your picks are losers.
In our example above, you have $50,000 in your account but because it is a margin account, you are able to purchase $100,000 worth of stock. The danger to you is that if the stock(s) you buy go down, your online broker has control of those stocks and can sell them in time to get their money back. In this scenario, you only have enough money to cover 1/2 of the purchase price so your broker owns the other half and has ultimate control should your account decrease in value.
This ONLY happens when you buy on margin and cannot happen when you buy stocks with your own money in a regular stock account.
What Is A Margin Call?
A margin call is what you get if your broker suddenly requires more money from you to keep your stock shares. If you aren’t able to add the required dollar amount to your account, your broker will sell the stocks in question in order to be able to recoup the dollars and get their money back. A margin call usually happens when the stocks you borrowed money to buy are going down. Your broker always needs to be sure you have enough money in your account to cover the amount you borrowed.
Why Do Investors Buy On Margin?
Investors buy on margin when they think they have a sure winner on their hands and want to buy more stock than they can actually afford. They are gambling the stock price will go up and if it does, everything will be great and they will make even more money.
But the perils come into play when the stock goes down and loses value. Investors who buy on margin can be sold out of their positions by their broker before they are ready to sell. For long term investors especially, buying on margin is a foolish thing to do for this very reason.
Likewise, I would advise all beginner investors to steer clear of buying stocks on margin. It is something that should ONLY be done by someone who has experience buying and selling stocks, clearly understands the risks, and is able to meet any margin calls in order to not be sold out of their stocks.