Buying on Margin – Overview
Buying on margin is one of the more complicated areas of investing.
In general, you should have a firm grasp of the basic types of securities available to you, an understanding of how the stock market works and a sizable amount of risk tolerance to start buying on margin.
While buying on margin can be a risky endeavor, it can absolutely be a valuable strategy for maximizing your gains and making your investing more profitable.
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Definition: What is Margin?
When you’re buying on margin, you’re essentially buying stocks with borrowed money.
Margin is like a line of credit that a brokerage allows you to invest with. The most important thing to realize here is that when you’re buy on margin you’re buying with borrowed money.
How Can you Buy on Margin?
To buy on margin, you have to open a special margin account with your brokerage. The brokerage will have a minimum amount of money that they require you to deposit in order to buy on margin.
By law, the most you can use margin for is 50% of the purchase price of your investment. So, if you wanted to buy a $10,000 investment, you would need to have at least $5,000 cash in your account, and then you could buy $10,000 worth of stock by tapping your margin.
How to Utilize Margin Wisely
Margin is primarily used to make short-term moves. This is because you’re going to pay interest on any amount you’ve utilized your margin account for.
The longer that you hold something you’ve bought on margin, the more interest will accrue. This means that when you eventually sell, your profits will be eroded by the amount of interest you have to pay on the margin account.
Buying on margin isn’t limited to just buying and holding securities until you want to sell them. Once you have a margin account, another option is opened to you that people without margin accounts don’t have access to. This option is known as ‘short selling’.
When you buy a security normally, you hope that the price will rise to increase your profit and equity. When you short sell something, you hope that the price of the stock will drop in order to make you money.
Essentially, with a margin account you can sell stock that you don’t currently own. Then, when the price drops, you can purchase it at a discount.
The differential between the short sell price and the actual purchase price represents your profit.
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A margin account is required by law before an investor can short sell. This is to defend against potential losses.
Basically, if you try to short sell a stock and the price rises instead, then you need to cover your losses somehow. Having margin means that there is some assurance that you can cover the loss even if you’ve experienced a cash loss on the deal.
In the U.S. some stocks cannot be sold short. This includes stocks in a company that just had an I.P.O.
New companies must trade for a month before anyone can short sell.
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