Why Buy Stocks on Margin?
Purchasing on margin means you’re purchasing your stocks with borrowed cash.
If you’re purchasing stocks outright, you pay $5,000 for 100 shares of a stock that costs $50 a share. They’re yours. You’ve paid for them free and clear.
But when you buy on margin, you are borrowing the money to purchase the stock. For example, you don’t have $5,000 for those 100 shares. A brokerage firm could lend you up to 50% of that in order to purchase the stock. All you need is $2,500 to buy the 100 shares of stock.
Most brokers set a minimum quantity of equity at $2,000. This implies that you have got to put in at least $2,000 for the acquisition of stocks.
For the loan, you pay interest. The brokerage is earning profits on your loan. They will also hold your stock as the collateral against the loan. If you default, they’ll take the stock. They have little risk in the deal.
A method to think of purchasing on margin is it is frequently similar to purchasing a home with a mortgage. You are taking out the loan in the hopes the price will go up and you’ll make cash. You are in charge of twice the quantity of shares. All you’ve got to see is the extra profit surpass the interest you’ve paid the brokerage.
Nevertheless there are risks to purchasing stock on margin. The cost of your stock could always go down. By law, the brokerage won’t be permitted to let the value of the collateral ( the cost of your stock ) go down below a certain proportion of the loan value. If the stock drops below that defined amount, the brokerage will issue a margin call on your stock.
The margin call means you’ll need to pay the brokerage the sum of money important to bring the agents risk down to the permitted level. If you do not have the money, your stock will be sold to repay the loan. If there’s any cash left, you’ll be sent it. Mostly, there’s little of your original investment remaining after the stock is sold.
Buying on margin could mean a huge return. But there is the risk that you could lose your original investment. As with any stock purchase there are risks, but when you are using borrowed money, the risk is increased.
Buying on margin is usually not a good idea for the beginner or normal, every day investor. It is something that sophisticated investors even have issues with. The risk can be high. Make sure that you understand all of the possible scenarios that could happen, good and bad.
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