Investing on the Margins? What to Know Before You Do
Posted by Richard on January 24, 2013
Margin accounts offer convenience, sophistication, and an integrated approach that allows you to fully capitalize on market opportunities. But investing on margin isn’t for everybody.
A margin account can be a valuable tool for investors seeking flexibility in managing their portfolios. Margin accounts offer convenience, sophistication, and an integrated approach that allows you to fully capitalize on market opportunities. But investing on margin isn’t for everybody. It involves elevated risk and is not appropriate for many situations.
How It Works
Like buying a house or car with the help of a loan, investing on margin simply means purchasing securities with borrowed funds. To purchase a stock on margin, you first need to have a margin account with a broker.1 Depending on the account, different securities may be permitted different levels of margin purchases. For example, you may be allowed to buy up to 75% of one stock on margin, while another may only allow up to 40%.
Margin accounts are typically subject to minimum account balances, which are often based on the loan-to-value ratio of the account (LTV). A margin call occurs when the total loan amount outstanding exceeds the security value of your investment portfolio. A margin call may occur due to a reduction to an LTV held within your investment portfolio. Alternatively, adverse market movements causing a decline in your investment portfolio may trigger a margin call.
To meet a margin call you would need to reduce your loan by depositing funds, provide additional approved investments to increase the security value of your investment portfolio, and/or sell sufficient investments to reduce your overall LTV level. If you do not meet a margin call within the specified time period, your broker may sell sufficient investments held by you to bring your loan back to an acceptable level.
To use margin successfully, it helps to set certain parameters and follow the best practices of seasoned margin investors.
• Use margin for appropriate assets. Your investing goals for a given investment account should dictate whether or not a margin investing strategy is appropriate. An everyday trading account seeking long-term growth that is used for multiple purposes might be the most appropriate, especially if you are an active trader.
• Be selective. As with any investment, it pays to know what you are investing in before you buy it. This is particularly important in a margin purchase, where a wrong guess can cost much more. Consider companies with strong fundamentals and those in growth industries with an established track record of long-term growth. Using margin accounts for the latest hot stock or to chase momentum stocks is risky.
• Keep it short. Investment professionals typically recommend limiting margin purchases to short periods of time. Consider setting one- or two-month windows for margin purchases so that you are not exposed for too long a period to unforeseen price drops or market corrections. And keep in mind that you are paying interest on your borrowed funds, which will lower your net investment return.
• Avoid margin calls. A margin call can force you to sell a holding at an inopportune time, locking in losses or missing out on a rally. Worse yet, your broker could liquidate your account for you. To avoid this situation, calculate up front your minimum maintenance requirement — typically 30% of the current value of the account — and make sure it does not go below this limit.
• Know when to get out. This holds true on both the winning and losing sides of a trade. If you’ve purchased a stock on margin that has subsequently had a good run, don’t get greedy. Likewise, set a limit as to how much of a loss you are willing to take before you sell, and stick to it. One of the most common mistakes investors make is to hold on to a loser too long.
A margin strategy executed prudently can be a valuable tool. But you have to be disciplined, know what you’re doing, and accept a high amount of risk.
1. Investing in stocks involves risk, including loss of principal.
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