Do you currently own stocks? If so, then you've probably opened a brokerage account in order to purchase stocks and invest for your future. As the manager of your own brokerage account, there's a very good chance you were asked during the registration process whether or not you'd prefer it to be a cash account or a margin account.
What's the difference?
A cash account allows you to only use deposited cash to buy and sell stocks, or to purchase basic stock options. This type of account doesn't allow investors to short-sell, or bet against stocks. Thus, if you're considering a cash account, understand that your primary purpose will be to buy low and sell high.
On the flip side, you can opt for a margin account (although most brokerages require a minimum of $2,000 in equity in order to access margin). Simply put, margin accounts let you borrow capital against your deposited or invested equity. As you might imagine, there are a handful of reasons why margin trading can be beneficial, and there are an equal number of terrifying risks you should be aware of.
Buying on margin: The pros
The greatest advantage to buying on margin is that it boosts your purchasing power. When you have a relatively small amount of money to work with, margin can be used to boost your returns or help diversify your portfolio.
Imagine for a moment that you have $2,000 to invest and you really want to sink it into Apple stock. If you were in a cash account you could buy around eight shares. However, depending on the level of margin that you qualify for (depends on the brokerage firm) and the margin requirements for each security (which is also set by the brokerage), you may qualify to buy anywhere from 12 to 24 shares of Apple in a margin account. If Apple stock rises $5 in a cash account you'll have made $40 (not including commission costs). However, in the margin account a $5 increase in Apple would net a profit of anywhere from $60 to $120 before commissions. This substantial leverage can be incredibly beneficial in a bull market, and it can be used to multiply your returns.
Another pro is that buying on margin gives you more investing options. With a cash account you're "stuck" buying stock or are confined to some very basic options strategies. In an account with margin capabilities you can bet against stocks (short-selling) or you can dabble in all types of stock option strategies, which grant you the right to buy or sell 100 shares of an underlying stock at a predetermined price. Both short-selling and options are inherently riskier than simply buying a stock and holding, but they offer additional ways for experienced investors to make money.
Buying on margin: The cons
But, as you might imagine, buying on margin comes with risks.
The biggest risk you have when buying on margin is that you don't know, with any certainty at least, that the stock you purchased or short-sold will do what you expect. Even the best stock pickers in the world are wrong around a third of the time, which means there's a lot of inherent risk in playing with margin.
For example, if the value of your investment(s) declines you may be required to deposit additional capital to cover your margin. In fact, it's possible to lose more money than your initial investment when buying on margin. Let's remember that margin is nothing more than a loan you've accepted from your broker. If your account equity isn't high enough to maintain your position, your broker will often allow a week to add additional funds to satisfy your "margin call" or "house call," otherwise it will liquidate some, or all, of your position. Ultimately, the broker needs to protect its loan, which means it will have no qualms about liquidating your position if you're not in compliance.
Another oft-overlooked disadvantage of buying on margin is that you'll owe interest on your loan. Just like with any bank, the higher the amount of the loan, or the more you trade, the lower your interest rate will be. But, make no mistake about it; your margin rate will be substantially higher than the prime rate. Currently, most investors buying on margin will owe about 8% per year on the amount they borrow. If you don't believe you'll make at least 8% per year, then investing with margin may be a poor idea.
Although, one caveat worth noting here is that you may qualify for a tax break based on the amount of interest you pay from your margin usage. This helps lessen the sting of your monthly interest payments (which are automatically collected by your brokerage firm) a bit, but it's still a major risk to consider when buying on margin.
Which strategy is right for you?
Ultimately that will come down to your risk tolerance and your knowledge of investing. If you're relatively green behind the ears, investing with margin may not be the best idea. The same goes for an investor who wants to avoid higher-risk situations such as short-selling and stock options.
However, if you're a seasoned investor and you fully comprehend the risks involved and have an intent on taking advantage of more complex options strategies, short-selling, and potentially even leveraging your buying power, then buying on margin could be a smart move.
To find out more about online brokers, and the features and fees associated with different account types they offer, use our broker comparison tool.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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