Should buying on margin be one of your investment strategies? Learn more about the potential risks and rewards of a margin account.
A margin account offers investors the chance to turbocharge gains, but can also magnify losses. Should the double-edged technique count among your investment strategies?
Than depends on your appetite for risk and level of expertise. According to Wilmington Trust, “Buying on margin can be tricky business and is not a venture on which a novice should embark.”
How does a margin account work? A margin account allows investors to borrow money from their brokerage firm to purchase securities, according to the Financial Industry Regulatory Authority, or FINRA, which oversees securities firms. So far this year, investors have purchased on margin an average of $320 billion in securities per month, according to FINRA. The volume has regulators worried that many investors “underestimate the risks of trading on margin.”
Investors open a margin account with an initial deposit, and secure a loan with securities that they purchase. Using the margin account, they can generally borrow up to 50 percent of the total purchase price for a new or “initial margin” purchase. FINRA rules require investors to maintain a balance in the margin account of at least 25 percent of the current market value of the securities in the account. Brokerage firms may impose higher margin requirements, and may do so for certain volatile stocks or a concentrated position in one stock, FINRA said. (Learn more about how Millionaire investors are responding to stock market volatility.)
Should the securities used as collateral drop in price, an investor could face a “margin call,” a demand from the securities firm to repay all or part of the loan. The margin call could force an investor to sell securities at an unfavorable time, creating “substantial losses,” according to FINRA. Margin trading also carries costs, because investors pay interest on their loans.
“While the rewards of buying on margin can be great, the potential losses can be just as dramatic,” according to Wilmington Trust. “For every 100 percent gain there is the potential for a 100 percent loss.”
In today’s uncertain and volatile markets, Millionaires appear unlikely to make trading on margin one of their go-to investment strategies, according to a wealth study conducted by Millionaire Corner in the first quarter of 2012. About one-third of Millionaires – investors with a net worth of $1 million to $5 million, not including primary residence – say they are willing to “take significant investment risk” on a portion of their investments in order to earn a high return. Nearly half (49 percent) say it’s more important to preserve, rather than grow wealth in the current economic environment. (Risk and diversification are the top two criteria of Millionaire investors.)
Still considering a margin account? It’s important you “fully understand how a margin account works,” advises FINRA, before you make trading on margin one of your investment strategies.