What is buying on margin?
Is it a facility that stockbrokers are giving for free to buy stocks?
As a trader or investor, you might have these kinds of questions. If you have, don’t worry, you are at the right place.
In this article we will define the term margin trading. And, we will tell you what are the things you should remember while buying stocks on margin.
Margin trading means you are buying stocks by using borrowed funds from your broker. It’s a loan from a broker to purchase stocks.
Now the question arises, what should you do? Will you buy stocks on margin? Or Will you borrow funds from your brokers to buy stocks? The answer to this question is: it depends on your trading strategy.
Margin account allows you to buy more stocks that you would be able to right now.
Many brokers are providing this facility if you have enough stocks with them as securities. This type of strategy helps in a favorable market. In case of a bear market, this strategy can backfire.
Let us analyze in detail to know how buying stocks on margin works.
How increase in share price impact your margin account
When the share price goes up after buying the stock on margin, it’s good news for you as you are making more money than the amount invested. But, hey wait a second, you need to calculate your actual profit to know exactly how much you got.
Your brokerage will not give you a loan to buy stocks for free. They will charge you interest, fees and commission on it.
Therefore, while calculating you need to deduct all these costs from the surplus money you got.
If your stock price moved up substantially within a short period of time, then well done, you have profit after taking out costs for availing margin.
But, remember the reverse is also possible.
For interest on the borrowed fund and other costs, you need to contact your stockbroker.
What happens when stock price goes down
This outcome is bad for you.
If the stock price goes down, then you are already making losses and for each passing day, you need to pay interest on margin.
When the stock moves down substantially, your losses are wide and you need to provide additional security to the broker.
Additional security is required to maintain the required balance between your debt and equity with the broker. This requirement depends on the stockbroker you choose.
By law, you need to maintain the minimum account balance before your broker will force you to deposit more funds or sell your stocks to pay down your loan. When your broker does this, it’s known as margin call.
Which means, when security provided by you against the debt is not enough, you are required to provide additional money or security by depositing cash or stock.
If you are unable to provide additional funds, then the broker will sell all those securities kept with them against the debt at current market price for settlement.
Therefore, before availing buying on margin facility, you need to make sure that your strategy of buying stock is proven and you are 100% sure to make money.
Whatever is your stock, experts suggest that you should not avail margin for buying stocks in a bear market. When your stock goes down drastically, you can end up losing your total market value in repayment of debt.
Tips for buying on margin
- Remember, buying on margin means borrowing money from your broker to purchase stocks. Therefore, you must read the agreement before getting into this type of transaction.
- If possible, avoid buying stocks on margin. At least not advisable for beginners who can’t understand the trend of the market. Margin trading is risky and not for all investors.
- Constantly monitor your stocks.
- Try to maintain a debt-equity ratio to minimize the chance of margin call.
- Consider buying stocks of fundamentally strong large companies that have a stable price and pay a good dividend.
- Have a payback plan for your debt.