Pros and Cons of Buying on Margin

Margin trading allows investors to borrow money from a brokerage to increase buying power. While it offers the potential for larger returns, it also increases the risk of losses that can exceed the initial investment. Risks like margin calls may require additional funds to cover losses, making it a strategy best suited for experienced investors. A financial advisor can help you determine whether you should buy on margin for your portfolio.

What Is Buying on Margin?

Margin trading involves borrowing money from a brokerage to buy stocks or other securities, allowing investors to purchase more shares than they could with only their available funds. This margin loan is secured by assets in the investor’s brokerage account.

To initiate a margin trade, investors must meet a minimum margin requirement set by the brokerage. This requirement usually involves having a percentage of the total trade value in cash or existing securities as collateral.

The way it works is, if an investor wants to buy $10,000 worth of stock but has only $5,000, they can use margin trading to borrow the remaining $5,000. If the stock price rises by 20%, the investment grows to $12,000, yielding a $2,000 profit, equal to a 40% return on the investor’s $5,000 cash investment.

Margin trading can also increase losses. For example, if a stock drops 20%, the investment value falls by $2,000 to $8,000, resulting in a 40% loss of the investor’s initial capital. In some cases, losses may even exceed the original investment.

Brokerages apply interest on margin loans, adding a cost to the trade that can accumulate over time, especially if the position is held for an extended period. Margin calls may also occur if the account’s equity falls below a set maintenance level, requiring the investor to deposit additional funds or liquidate holdings to meet this threshold. The leverage offered by margin trading can appeal to experienced traders, but it requires careful risk management.

Benefits of Buying on Margin

Margin trading allows investors to borrow funds to buy more securities, potentially increasing returns and diversifying their portfolios beyond what cash investments alone can achieve. Here are five common benefits to consider:

Increased buying power. Margin trading lets investors borrow funds from their brokerage to buy more securities, increasing their buying power beyond their available cash. This allows them to take larger positions in stocks or other assets without using more personal funds upfront.
Potential for higher returns. Gains are based on the total value of the securities, not just the investor’s contribution, so even small price increases can result in significant profits. For example, a 10% gain on a leveraged position generates a higher return on the initial investment compared to a cash-only purchase.
Flexibility in investment choices. Margin trading gives investors flexibility to diversify or seize short-term market opportunities. With borrowed funds, investors can take new positions quickly, which can be helpful in volatile markets where timing is important for capturing gains.
Short-selling opportunities. Margin accounts are required for short selling, where traders borrow shares to sell them, aiming to buy them back at a lower price. This allows experienced traders to profit from falling stock prices and trade in both rising and declining markets.
Interest may be deductible. Interest on margin loans may be tax-deductible if the borrowed funds are used to buy investments that generate taxable income, qualifying as an investment interest expense deduction.

Risks of Buying on Margin

Margin trading involves risks, as leveraging can deplete an investor’s capital faster than traditional trading. It also comes with specific challenges that require careful management. Here are five common ones to keep in mind:

Magnified losses. Margin trading can increase gains but also increases losses, which can exceed the original investment. Losses are based on the full leveraged position, not just the investor’s cash. In volatile markets, this can quickly wipe out the account’s value.
Margin calls. If the equity in a margin account drops below the brokerage’s required level, a margin call is issued. The investor must add funds or sell holdings to cover the shortfall, and if they fail to do so, the brokerage may sell assets at unfavorable prices, causing more losses.
Interest costs. Borrowing on margin incurs interest charges, which can reduce profits as well as increase losses. Interest rates vary by brokerage and market conditions, and the cost can become significant, particularly for positions held long-term or during rising interest rate environments.
Market volatility. Leveraged investments are highly affected by market fluctuations, with rapid price changes posing risks. Volatility can lead to margin calls or large losses, and sudden market downturns may quickly deplete capital, even for well-planned trades.
Emotional and psychological pressure. The higher risks and rapid losses in margin trading can cause emotional stress, leading to impulsive decisions and poor outcomes. Handling leveraged positions during market pressure is difficult, even for experienced investors.

Bottom Line

Margin trading allows investors to use borrowed funds for larger positions and faster responses to market opportunities. While it offers potential rewards, it also comes with risks like larger losses, margin calls, and interest costs, which can be heightened by market volatility and the stress of managing leveraged positions.

Investment Planning Tips

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