When you buy on margin, you're using the securities in your portfolio as collateral for a loan from your broker that you can use to buy more securities. You might use margin to take advantage of a unique opportunity when you don’t have enough cash on hand or you don’t want to sell any of the securities you already own to cover the cost.
Now, you can generally borrow up to 50% of the costs of the securities you are buying with the funds from the margin account. This will allow you to purchase twice as much as you could with just cash. In other words, you pay for half of the cost and you borrow the other half from your broker.
So let’s work through an example.
As you're doing your research, you find a stock that you think has upside profit potential. It’s trading at $100 a share, and you have $10,000 to invest, so you could buy 100 shares. But you’d like to buy more than that. If you buy on margin, you can invest twice as much and buy 200 shares (200 x $100 = $20,000).
Assuming your careful research turned out to be right and the stock goes up 25%, your 200 shares would be worth $25,000. If you decide to sell at this price, the $10,000 loan from your broker will automatically be repaid, and you'll be left with a $5,000 profit, instead of just $2,500. While the stock only went up 25%, you realized a 50% profit by using margin.
But what if your stock declines in price by 25%? Well then, your 200 shares would be worth only $15,000. If you choose to sell at this price, the $10,000 loan from your broker will be repaid automatically, and you'll be left with a $5,000 loss. While the stock only declined by 25%, you ended up with a 50% loss, and by using margin, you lost $5,000 instead of just $2,500.
Additionally, just like with any other loan, you'll have to pay interest on the loan, and that will either decrease your profit or increase your loss. But unlike most loans that you may be familiar with, a margin loan does not have a set repayment schedule. Instead, the loan is paid in full when the securities are sold.
However, when you use margin to buy stock, the margin interest is often tax-deductible against your capital gains and investment income.
Now margin trading has unique risks. In order to decide if margin trading is right for you, it's important to understand these risks, as well as your own personal risk tolerance.
If you'd like to learn more, check out the next video on the risks of margin trading.