Why was Stock Bought on Margin Considered a Risky Investment?

Although margin loans are convenient and effective, stocks bought on margin are considered a risky investment. Though you can buy more stocks with little cash, you could potentially lose more money than you can afford and not be able to repay the loan. In case of a downturn, you are responsible for the loss and must repay the loan.

What would you do if there was a way to double or triple your stock market returns

If you have limited capital, you can borrow money against your existing stock investments from your broker at a relatively low interest rate, also known as margin trading. You may have already experienced this if you use a brokerage such as Robinhood, which automatically enables margin accounts for its users. If you have instant deposits for any of your investment accounts, you are most likely using margin when you purchase stocks.

Think of margin investing as taking out a loan to buy stocks and using your existing stocks as collateral. While buying on margin allows you to leverage your returns, using margin is considered a risky investment. Margin trading enables aggressive investors to double down on their investing and trading strategies by allowing them to buy more shares than they can afford. When everything goes well, you could see exponential returns. However, if your plan flops, you could lose everything.

Even though there are many advantages to margin trading, stocks bought on margin are risky. If you are thinking of using margin, let's consider all the benefits and risks first so you know what you are getting yourself into.

The Benefits

Faster, Easier Liquidity

One of the perks of using margin is having faster and easier liquidity. As mentioned earlier, if you have a margin account enabled on your brokerage, you will have access to the instant deposit feature. The ability to use the money you deposit into your account instantly is valuable when you want to make a quick trade or need capital to buy stocks immediately. Even though I do not buy stocks on margin, I use margin accounts across all my investment accounts for convenience.

Inexpensive and Flexible Loan

Most brokerages offer relatively low-interest rates for using margin and have flexible repayment. For example, Webull currently has a 9.49% annual margin rate if you have a debit balance of less than $25,000, and the rate decreases with each set bracket (as of December 2022). If you use margin to day trade or swing trade, you can repay the loan in a few days or weeks if you make a successful trade. Unlike a credit card loan or car payment, using margin is much more flexible. Generally, your brokerage firm will allow you to repay the loan on your schedule.

Leverage Assets

Margin trading allows you to leverage the value of securities you already own to increase your investment size. By using margin, you can buy stocks with little cash on hand. If everything goes as planned, you can magnify potential returns.

For example, if your account has $5,000, you can borrow up to 50% against it, meaning you have up to $10,000 in purchasing power. You can take the $5,000 initial investment and the $5,000 borrowed from your brokerage to buy a total of $10,000 of stocks. If you make 20% in returns, your profit will be $2,000 instead of $1,000 if you did not use margin.

A sophisticated strategy that some investors and traders use is short-selling or borrowing shares of stock from a broker to make profits when the share price declines. To short a stock, you need to have an approved margin account. The strategy here is to sell the shares at the borrowed price and then repurchase them at a lower price to return to the brokerage. The difference between the two prices would be your profit.

The Risks

Maintenance Margin

Stocks purchased on margin are considered a risky investment because your account needs to stay above a maintenance margin of at least 25%. In other words, you must have at least 25% equity in any stocks purchased on margin. Depending on the margin agreement you have with your brokerage, the maintenance margin may be higher.

If the value of your stocks decreases substantially or falls below the maintenance margin, you could be subject to a margin call, which will require you to either add more money to your account or liquidate your stocks. Because your brokerage is loaning you money, you are responsible for the loss.

You generally need a substantial return to make money and avoid getting margin called if you choose to use margin. Depending on your strategy, the interest rates to buy stocks on margin can add up over time if you do not repay your loans. 

Amplified Losses 

In the same way, in which leverage can amplify your wins, it can also amplify losses. The stock market is highly volatile and unpredictable, so you will not always get every trade right. In addition, you may need a substantial return to make back the cost of interest at the minimum.

The more you invest using margin, the more you have to lose. If you incur a margin call and do not have enough capital to cover it, your brokerage firm can liquidate your securities without asking you. The possibility of a margin call is something to keep in mind if you are planning on trading highly risky securities, particularly crypto. However, paying off the interest regularly and having a cash cushion will help to reduce the likelihood of this happening. 

The Bottom Line

While leverage provides an opportunity to make money faster, stocks purchased on margin come with substantial risks. You need to do your research and decide if margin trading is the right strategy for you. If you find that leverage provides little or no value to you, stick with a cash account. If the benefits of using margin outweigh the costs, then manage your risk accordingly.

We are not financial advisors. The content on this website and our YouTube videos are for educational purposes only and merely cite our own personal opinions. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know that all investments involve some form of risk and there is no guarantee that you will be successful in making, saving, or investing money; nor is there any guarantee that you won't experience any loss when investing. Always remember to make smart decisions and do your own research!

Leave a Comment