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Buying on margin can mean potentially higher returns – but it can also lead to large losses very fast.
[This article outlines 6 things to know about buying on margin and 3 key risks of doing so.]
You may be able to borrow money from your investment firm to pay for part of your investments. This is called buying on margin. Buying on margin allows you to buy more shares than you would normally be able to afford – it’s a way of using leverage. This may mean potentially greater returns. But it also comes with greater risks – you can lose more money than you originally invested.
6 things to know about buying on margin:
- Margin account – You have to open a margin account to buy on margin.
- Minimum investment amount – The investment firm sets the minimum amount you must deposit in a margin account. This is sometimes called the minimum margin.
- How much you can borrow – This depends on the price of the stocks you’re buying. Your investment firm may lend you up to 70% of the money you invest. This is called your maximum loan value.
- Interest charges – The interest charges on the loan are applied to your account. Depending on what you invest in, you may be able to deduct the interest on money you borrow to invest.
- Collateral for the loan – The stocks you buy are used as collateral for the loan. You have to keep enough assets in your margin account to cover the loan value at all times.
- Margin call – If your stocks drop in value, your investment firm may ask you to put more money into your account to maintain your margin. This is known as a margin call. If you don’t put in more money, the firm has the right to sell your stocks and other investments in your account to cover the margin call.
Read your margin account agreement
When you open a margin account, you sign a margin agreement. Read it carefully to understand how the stocks you buy serve as collateral for the loan, your responsibilities for repaying the loan and how interest is calculated.
How much you can borrow
The Investment Industry Regulatory Organization of Canada (IIROC) sets minimum standards based on the price of a stock. Ask your financial advisor what the standards are in your country and keep in mind that some] investments firm may impose more stringent requirements in certain situations.
| Share price | Maximum loan value |
|---|---|
| Less than $1.50 | No loan allowed |
| $1.50 to $1.74 | 20% |
| $1.75 to $1.99 | 40% |
| $2.00 or more | 50% |
| Eligible for reduced margin* | 70% |
* Stocks with low volatility and high liquidity, making them easier to buy and sell
Example:
- You have $10,000 to invest and you want to buy shares of ABC Company at $10 a share.
- Your investment firm agrees to lend you another $10,000 on margin.
- You invest the entire $20,000 in 2,000 shares at $10 a share.
- You agree to keep $10,000 in assets in your account at all times to cover this loan.
What happens next? Let’s look at 2 scenarios.
- You sell the shares for $24,000 – a 40% return on your original $10,000 investment. If you had paid cash for the shares, you would have made $2,000 on your $10,000 investment or 20%.
- You pay back the loan and interest, and pay trading commissions to your investment firm.
- After costs, your profit would be still higher than if you had invested without borrowing.
- Your investment falls to $16,000 and you have a loss of $4,000 on paper. You could sell the shares and take the loss, but you decide to hold onto them in the hope that they may go up again in the future.
- You have to keep paying interest on the loan.
- You also have a margin call. That’s because your investment firm is only allowed to lend you up to 50% of the current market value of your investment. Since your shares are now worth $16,000, you can only borrow $8,000 on margin. Your current loan is $10,000, which means you’ll have to add $2,000 to your account to make up the difference and maintain your margin.
Practise before you buy on margin
Buying on margin is complicated and comes with many risks. To learn more, try this margin account simulation from the North American Securities Administrators Association.
3 key risks
- You can lose more than you invested – If your investments go down in value, you still have to pay back your loan and interest. You may have to put up more margin to maintain your account. If you don’t, your investment firm can sell your investments to cover the margin call. You could lose more money than what you originally invested.
- It costs more to invest – In addition to trading commissions, you have to pay interest on the loan. Depending on what you invest in, you may be able to deduct the interest on money you borrow to invest.
- The interest rate can go up – The interest rate on your margin account can change at any time. It may cost you a lot more than you thought to pay back what you borrowed.
The comments above are edited ([ ]) and abridged (…) excerpts from the original article by Investor Education Fund (www.getsmarteraboutmoney.ca)
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