Most people who buy stocks do so by buying and selling them through brokerage accounts. Typically, an investor will deposit money into their account and then buy either individual stocks or groups of stocks set up in mutual funds or index funds. The investor can also buy bonds and other securities.
The purchases and sales are easy to understand – if a stock costs $100, then the investor will pay this price to own one share of the stock, plus any trading fees that are charged by the exchange. However, some traders indulge in something called margin trading.
Definition of Buying on Margin
According to SoFi Invest, “Margin trading, or buying on margin, means to buy on credit. Or, to borrow funds to pay for an investment in order to buy more of an asset than you’d otherwise be able to.”
When someone buys stocks on margin, they are essentially getting a loan. The investor borrows money in order to buy the stock. At some point, the loan will need to be repaid, along with accrued interest.
Given these factors, why would anyone buy on margin?
It’s for the same reason that people take out loans to buy a house or companies take out loans to purchase equipment. These funds require a good credit standing before funding will be granted. Consulting a credit repair firm to oversee your credit check process and dispute any mistakes on your behalf, allows for a streamlined process; Specialist credit repair firms like Fair Credit and Credit Saint are amongst the many firms worth consulting.
While the potential returns of using leverage can be very attractive, risks are also involved. Just as profits can be magnified by trading on margin, so can losses. A good option for lowering risk is a funded trading account.
Example of Margin Trade
Let’s say that an investor wants to buy 100 shares of a company for $10 a share but only has $500 in cash in the investment account. The investor could purchase the shares on margin, using the $500 to cover part of the cost and borrowing the other $500.
If the price of the shares rises to $15 a share, then the investor can sell them for a profit and essentially double their money after paying back the amount borrowed. The investor can put in $500 and walk away with $1000.
By trading on margin, the investor doubled their profit with the same amount of cash.
However, what if the price of the stock had dropped?
If the price of the stock had dropped to $8, then instead of walking away with $1000 after paying back the $500 borrowed, the investor would have lost money. They would have gotten $800 and then had to pay back the borrowed money, thus losing $200, whereas if they hadn’t bought on margin, the loss would only have been $100.
What if the stock price had dropped to $4 a share? The investor would get $400 for the stock sale but would still owe $500 to pay back the loan. In addition to losing the $500 investment, they would lose an additional $100 to cover the cost of the debt. So the investor’s total loss would be $600, even though they only invested $500 of their own money into purchasing the stock.
Investors need to be aware that it is possible to lose more of your own money than the amount you invest when using leverage.