Become a better investor
Lesson in Course: Stocks (expert, 7min )
We learned about levers as kids (think seesaw). How can we make our money do more work with less effort?
We might not remember the lesson about these simple machines from school, but hopefully, the image below looks familiar. If we were feeling devious that day, maybe we swapped out the box of markers for erasers and launched them to the moon!
Our favorite philosopher, Archimedes, was caught saying:
“Give me a lever long enough and a fulcrum on which to place it, and I will move the world.”
This wise guy knew that, with enough leverage, a little effort could make big things happen. The same principle applies to investing. By using margin, we can apply leverage to magnify returns with less money.
In a cash account, we need the full cash amount to buy or sell an investment. On the other hand, a margin account allows us to make trades with some of our cash or investments and borrow the rest using the investments and cash in the account as collateral. Some types of trading, such as stock options or short-selling, can only be done in margin accounts.
The concept is similar to getting a mortgage to buy a house. The bank keeps the house as collateral until we pay off the loan. Collateral in our margin account assures our broker that we can pay back what we borrowed.
Borrowing money like this is known as leveraging your position. A leveraged position amplifies the potential gains and losses of an investment.
Let’s say we want to buy a share of Amazon, AMZN, and it’s trading at $3,000 per share, but we only have $1,500 of cash available. In a margin account, we can borrow the other $1,500 to make the purchase.
Imagine the share price goes up to $3,500, and we sell our share. We’d pay back the $1,500 we borrowed on margin and pocket the other $2,000. This is a $500 profit on our $1,500 investment, a sweet 33% return.
If we bought the share in a cash account, we would have put up all $3,000, and our $500 profit would be a 17% return. Still a nice return but not as high as if we bought the share on margin.
Now imagine the share price goes down to $2,500, and we sell our share. We’d pay back the $1,500 we borrowed on margin and pocket the other $1,000. This would be a $500 loss on our $1,500 investment, a rough 33% loss.
If we bought the share in a cash account, we would have put up all $3,000, and our $500 loss would be a 17% loss—still a tough loss but not as bad as if we bought the share on margin.
As with any loan, the margin balance, the amount we borrowed, will accrue interest. The difference is that there is no repayment schedule as long as we hold enough collateral in the account. Brokerages may require us to keep somewhere between 25% - 40% of the total account value as collateral, either cash or the value of your investments. If the value of our collateral falls below that, we’re faced with a margin call.
A margin call means that we need to add more collateral to our account. We can add cash, add other investments, or close some positions to lower the margin balance. If we don’t meet the margin call, our broker has the right to close out any open positions, such as forcing a sale of stock, without our approval.
From our example, let’s say the price of AMZN stock plummeted to $2,000, and the maintenance margin is 30%. That means our collateral, the value of our equity in AMZN is $500 ($2,000 account value - $1,500 borrowed on margin) and is only 25% of the account value. Since this is less than the 30% we need to keep in the account, we have to meet a margin call.
Investing with margin can be a powerful tool to increase your returns, but it’s riskier. Consider your risk tolerance and your financial circumstances since you’ll have to pay interest on the margin loan and be required to deposit more money or investments if your account falls to a point where you’re faced with a margin call. You can limit these risks by using protective stop orders that limit losses from any stock positions and keeping enough collateral in the account.