“Leverage” means investing with cash that is, at a fixed rate, borrowed in the hopes of earning a greater rate of return. Like the lever, the simple machine for which it is named, leverage lets you use a small amount of cash to exert a lot of financial power. Many companies use leverage, called “trading on equity,” when they issue both stocks and bonds. Their earnings per share may increase because they expand operations with the money raised by bonds. But they must use some of the earnings to repay the interest on the bonds.
To buy on margin, you set up a margin account with a broker and transfer the required minimum in cash or securities to the account. Then, you can borrow up to 50% of the stock’s price and buy with the combined funds. For example, if you bought 1,000 shares at $10 a share, your total cost would be $10,000. By buying on margin, you put up $5,000 and borrow the remaining $5,000. If you then sell when the stock price rises to $15 you would get $15,000. You then repay the $5,000 borrowed (plus interest) and keep the $10,000 balance. This means that you can grab almost 100-percent profit margins with less money. A virtual profit-making machine if used appropriately and with caution.
Buying on margin is a great way to make insane amounts of revenue off of stock trades, but the downside risk is staggering. Nevertheless, if you want to increase the potential return on any stock investment, making an educated bet with a margin call is one of the best and easiest investing ideas around. You can borrow up to 50% of the total value from your broker. If you can sell the stock at a higher price than it originally cost, you can repay the loan, plus interest and commission, and keep the profit. However, supposing that you make a bad call, you still have to repay the loan. This means that your losses could be larger than if you had owned the stock outright.
In the event that the value of your trade falls below the required price floor, the firm issues a margin call. You must either meet the call by adding money to your account to bring it up to the required minimum or sell the stock and take your losses then and there. When the margin call comes, there’s still a cushion of 25% protecting your broker’s share. Because your shares will be automatically sold if you do not act on the margin call, your money is always at risk. In fact, your broker could even sell other stock in your margin account in order to recoup a loss that selling the shares didn’t cover.
Despite its potential rewards, buying on margin can be very risky. For example, the value of the stock you buy could drop so much that you could lose the entire amount you invested and perhaps more. As a measure to protect consumers and investing firms from downside losses, the New York Stock Exchange (NYSE) and NASD, formerly the National Association of Securities Dealers, require that you maintain a margin account balance of at least 25% of the purchase price of and stock you buy long. Individual firms may require an even higher margin level, close to 30%, but not a lower one.
There are a lot of profits and many losses that come at the hands of margin accounts. Holding a margin account and trading stocks for high returns with money that you essentially borrow could potentially be one of your most impressive investing ideas to date. It’s a sure fire way to run the table with your investments. If you are too heavily leveraged, it is important to be aware that “panic selling” can be a real problem. That is one reason that the Securities and Exchange Commission (SEC) instituted what is known as Regulation T, which limits the leveraged portion of any margin purchase to 50%. Investing in stocks on margin calls is a thrill ride, but never forget that you have money at risk if you are using money that isn’t yours.
You must log in to post a comment.