So You Want to Buy on Margin?

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You know that stock that's going gangbusters? The one that's just too good to pass up? The one you really can't afford? Yeah. But wait: What if you bought that stock on margin? Then you could afford it, and the clouds would part, and the angels would sing as all that money was deposited straight into your bank account. Huzza! 

Well, let's back up a few steps, shall we?

Buying on margin is a bit like gambling and using your car as collateral; it might turn out OK, but often, you're going to lose your ride home. Let's take a closer look.

Hurray for credit!
Imagine it's 1985. You've heard about this company called Apple (Nasdaq: AAPL  ) , and you just know it's going somewhere. The stock's cheap at $15 a share, and you really want to buy 100 shares. Unfortunately, you only have $750 available, so you decide to buy the other 50 shares using margin.

Luckily, Apple is the company you think it is, and a couple years later, your 100 shares are worth $8,000, and you've decided to sell. So what are you left with before taxes? Well, first you have to pay back the margin loan of $750, along with interest. But whatever's left after covering the loan and interest is yours to keep. That's not bad considering you started out with $750.

The down and dirty
But let's consider another scenario. This time, it's the present, and you just know Apple is going to continue its upward climb with the anticipated release of the iPhone 5. Plus, shares are down slightly at $330 a share, so you want to buy 10 shares. This time you have $1,650 of your own and you borrow $1,650 on margin.

Now fast forward five years. In this hypothetical future, things don't turn out so well for Apple. As a result, shares plummet to $200. So your initial purchase of $3,300 is now worth $2,000. You still have to pay back your $1,650 margin loan, so you end up with just $350, less any interest you have to pay. Ouch.

You might be wondering, "Does this actually ever happen?" Yes, it does -- even to high-profile investors who arguably should know better. Just ask Aubrey McClendon of Chesapeake Energy (NYSE: CHK  ) , who had to sell almost his entire stake in the company to pay back margin loans when the stock plummeted in 2008. Other past victims include Cedar Fair (NYSE: FUN  ) CEO Richard Kinzel, who had to sell shares because of a margin call.

Is it worth it?
Yes, investing on margin has the ability to bring in lots of profit. But, so does winning the lottery. Unfortunately, the chances of hitting it big with either are slim. When you invest your own money, you have the ability to grow it as high as the stock goes, whether that's 10% to 3,000%, while you can only lose what you put in. When you invest using margin, you're not only risking your own money; you're risking the margin and taking on the obligation to pay interest. For a $100 investment, that doesn't seem like much, but if you have $10,000 on margin, things start to look a lot scarier.

Investing money you can't afford to lose is definitely a no-no for Fools. And if you had it to lose, you wouldn't need margins anyway. Want to learn more about margin accounts? Click on the link, or head on over to our Foolsaurus for more information!

Fool contributor Katie Spence stays far, far away from margin accounts. She neither has one, nor owns shares of any company named above.

The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy and Apple, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (5) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 26, 2011, at 5:02 PM, mattack2 wrote:

    You also get to deduct margin interest paid. Though I have only used it for a very short time a few times (so I could buy something sooner than I could get money into the acct).

  • Report this Comment On May 26, 2011, at 11:54 PM, mm5525 wrote:

    I certainly don't recommend margin for beginners, but margin is great for some short-term trading income when you can nibble on some bargins on a day of gloom and doom in the market and get rid of it a few hours or days later. Another good side of margin is to buy dividend payers who basically come very close to canceling out the margin interest you're paying.

  • Report this Comment On May 27, 2011, at 2:51 AM, slard271 wrote:

    This article misses the mark on what margin is supposed to be and instead it is painted as a sure-fire means to loss of entire investments.

    Margin is a tool, just like any other instrument monetary or otherwise. Using margin wisely as some other posters have commented can be quite lucrative. Using margin poorly and without any self-education is indeed a recipe for failure. I personally don't blame the margin in that case and will happily keep it in my employ.

  • Report this Comment On May 27, 2011, at 3:50 AM, kariku wrote:

    The analysis is not quite accurate. Say you would like to buy 100 shares of AAPL at 330, hoping they will climb to 400 for a 7000 profit. You also intend to get out if the price drops bellow 300, so that you limit your risk to 3000.

    In both cases: buying the shares, or buying on margin, you risk 3000, but in the first case you would have to block the whole amount of 33000, if you have it in the first place.

    That being said, here are the drawbacks and disadvantages associated with margin trading:

    1. You have to pay interest on the borrowed amount (30000 in this example, assuming that you have 3000 for the margin, and the bank would actually give you such a large loan)

    2. The bank may close your position at any time, if your loss exceeds the margin, potentially causing you big losses. Think about May 6th, 2010: the bank closing your margin positions works exactly like a stop order. Besides, you may never get a margin call, to increase the margin if you wish so. For example, IB doesn't call.

    3. You may lose more than your initial investment. That's IMO the most dangerous fact, and it happens when there are sudden drops in price, especially during the overnight gap. Say today AAPL closes at 305, so you still keep the position open, but tomorrow it opens at 290. The bank closes your position immediately, the proceeds are 29000 so you still owe 1000 to the bank, after losing your whole margin of 3000, for a total loss of 4000. So I emphasize it again: you may end up owing money!

  • Report this Comment On May 27, 2011, at 4:16 AM, TempoAllegro wrote:

    Does this article miss the mark, really? I think not. It warns us of the pitfalls of using margin, which all too often outweigh the benefits for the majority of investors.

    My TD Ameritrade account is a margin account. The interest rate they charge for margin, which is calculated daily, is 9%. I suspect it would be hard to find good dividend payers that would offset that charge. It's hard enough to match or even beat the market with a 9% gorilla on your back as well!

    Now, I'm not saying it's not ever useful. Yes, if you are getting your money to the account soon, and you feel an urgency about getting a stock, perhaps before the ex-dividend date, go for it. But I know for me it's often a temptation to get something I want that I cannot currently afford and I just IGNORE the interest charged to me. Bad idea, right?

    Margin basically is leverage for good or bad. It doubles the effect of your choices. In the second example above, I chose to look at it like this - I bought 5 shares of Apple on my own at $330. I borrow the money for the other 5 shares, that's $1650 borrowed for 5 years. Let's say it's borrowed at 10% to make it easy to figure. That $825 just in borrowing costs plus the $15 broker fee. I come up with a cost to me of $2490. OK, So I've spent about $2500 and at the end the 10 shares are worth $2000, so that covers the other 5 shares ($1650 getting 0% for five years - like putting it under the mattress) and leaves me with just $350 left on the 5 shares I borrowed to buy. This means I have lost $2150 on this transaction simply because I did not want to do it with my own money. If I had just used my own money and no margin, then I would have just bought 5 shares at $330, seen it go down to $200 and then have a loss of $650. The loss is less than one third of what would have happened on margin due to the 5-year period it took me to wake up and sell those shares.

    I hope this helps! I know someone who has margin - I mean he owes his broker - $40,000, and I fear he will have a very rude awakening one day! Let's hope the market stays up for him! Margin is especially dangerous when the market crashes as that is when you are likely to experience a margin call.

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