One of the most common mistakes I see new traders make is buying on margin. They do it before they have enough experience to understand the risks.
Most new traders enter the market with a few hundred or thousand dollars. That’s typically money they can afford to lose. But if you start trading with borrowed money or money you need to pay your rent next month, I’ve gotta say something: DON’T do it.
Trading is a dangerous profession. Scores of day traders lose money in their first year. It takes time to become consistently profitable. Save up some money and give yourself a real chance of becoming one of my successful students.
If you’re starting with a small account, let me explain why you should avoid buying on margin at all costs…
Table of Contents
- 1 What Is Buying on Margin?
- 2 Buying On Margin vs. Short Selling
- 3 How Do You Buy on Margin?
- 4 Buying on Margin Examples
- 5 How Does Buying Stock on Margin Work?
- 6 The Advantages of Buying on Margin
- 7 The Risks of Buying on Margin
- 8 Frequently Asked Questions About Buying on Margin
- 9 Conclusion
What Is Buying on Margin?
Buying on margin happens with nearly all asset classes. If you purchase a house, odds are you’ll buy it on margin. You put about 20% down and finance the remaining 80%. When you buy anything using margin, it simply means a part of the purchase is borrowed money from a bank or a broker.
The same way you can buy a house with a small down payment, traders can buy stocks on margin to increase the number of shares they’re eligible to purchase. This can be tempting for a lot of people…
Buying stocks on margin — in theory — can allow traders to make more money quickly. But the risks are substantially higher.
In the U.S., traders and investors are limited by the pattern day trader (PDT) rule. One stipulation of this rule limits the level of margin accessible to traders with accounts under $25,000. While under the PDT, traders only have access to a 2:1 margin. So traders with $5,000 accounts can buy $10,000 worth of stock.
But traders over the PDT rule can buy stocks intraday on margin at a 4:1 ratio. That high level of leverage is very dangerous to inexperienced traders … but we’ll dig deeper into that in a bit.
Buying On Margin vs. Short Selling
Note that buying on margin isn’t the same as short selling. Both strategies require a margin account but have very different implementations.
When you short sell, you need a margin account. You’re selling an instrument you don’t own. The cash in your account is collateral for the position to ensure you’ll buy back the shorted shares in the future.
Buying stocks on margin uses the same collateral principle, but you’re using money you don’t have instead of selling a stock you don’t own. The cash in your margin account is the broker’s guarantee on the loaned margin. The broker will liquidate your position if your position moves sharply against you and puts their loan at risk.
So say you’re a trader under the PDT, using your full margin, and the stock drops by 50%. The broker has the right to liquidate your account. The liquidation clause is part of the margin account agreement you sign when you open a margin account.
How Do You Buy on Margin?
The first step to buy on margin is to open a margin account with your broker.
Most brokers default new accounts to a cash account. Any trader can have a cash account, regardless of their credit history. Assuming you have a solid credit history, you can open a margin account with most brokers by filling out a simple form.
Next, you need to have enough money to meet the broker’s margin requirements. Every broker has a different margin requirement. Some overseas brokers have a margin requirement as low as $500. Many licensed brokers in the U.S. have a margin requirement of $2,000.
Once you have a margin account, buying on margin is pretty straightforward. When you try to make a purchase, your broker will inform you of the amount of margin you can use on a given stock.
It’s common that volatile or sketchy penny stocks are margin restricted. That means you can’t use margin because the broker isn’t willing to lend you margin. However, stable companies like blue-chip stocks are rarely margin restricted.
You have to be smart with this leveraging power. You’d be surprised how often people message me because they blew up their accounts using margin … AND we haven’t even discussed margin interest costs yet.
Buying on Margin Examples
Most people are unfamiliar with buying on margin — they’ve always used a cash account.
So let’s walk through an example.
Let’s say you research company XYZ and think the stock will be an excellent investment for 2020. I’ll keep this simple and ignore any fees or interest charges your broker will charge you.
Currently, company XYZ trades for $100 per share. You’d like to purchase 100 shares of XYZ, which would cost you $10,000 without margin. However, you have a margin account under the PDT. Your broker allows you to use 2:1 leverage on the cash in your account.
Now, instead of having to use $10,000 to buy 100 shares, you only need to have $5,000 in your account. You buy the other $5,000 on margin.
After owning the stock for one year, XYZ’s price doubles to $200 a share. Since you were right about the investment, you decide to sell your shares and collect $20,000. But you gotta pay the broker back that $5,000.
Once you pay the broker back, you have $15,000. You tripled your account in one year. Those 200% gains are great, right? Let’s look at the other side of this story…
In another reality, stock XYZ had a tough year and lost half its value. It ends the year at $50 per share. You sell your shares for $5,000. Even though the stock lost its value, you still have to pay the broker back the $5,000 they loaned you. So one bad investment resulted in your losing your entire account.
So yeah … buying on margin can mean awesome gains … But the harsh reality is the possibility of blowing up your account. If you used a cash account in this case, you’d still lose money. But you wouldn’t have blown up your entire account on one trade.
How Does Buying Stock on Margin Work?
There’s nothing new about buying stocks on margin. Traders, brokers, and investors have used margin for most of the stock market’s lifetime.
At its core, margin is a loan from your broker. And the broker charges an interest rate. Typically, the interest rate on margin is lower than credit card interest. But it can eat into your profit potential if you use margin for an extended period of time.
Specific margin interest rates depend on your broker and the overall interest rates in the economy.
To simplify this, suppose your broker charges 10% interest annually for any margin used. If you use margin for a short period, you won’t be charged the full 10% annual rate. The amount of interest you pay for the margin loan depends on how long you hold the stock position.
Here’s how you can calculate the borrowing cost:
- Take the amount of money you borrowed ($5,000 from the example above).
- Multiply that amount by the interest rate ($5,000 x 10% = $500).
- Divide the calculated number by the number of days in a year ($500 / 365 days = 1.369).
- Multiply by the number of days you used the margin, for this example 10 days (1.369 x 10 = $13.69)
In this example, if you hold the stock for ten days, you’d pay $13.69 in interest on the $5,000 margin to purchase stock XYZ.
The Advantages of Buying on Margin
I’m sure you can imagine the massive advantages of using margin with your investing. It can be tempting to want to go all-in with margin. But it’s extremely dangerous.
Could your investment double? Sure…
But it could just as quickly drop by 50%.
One good trade could potentially be life-changing, but you can’t think of the stock market like a lottery ticket.
It takes time to become a consistent trader. One massive trade won’t make that happen. All of my top students learned to take small wins and cut losses over and over again. That’s exactly what I teach in my Trading Challenge.
The Risks of Buying on Margin
From all the people I’ve taught over the last ten years, very few were successful using margin in their first few years of trading. The leverage is too dangerous for newbies.
The learning curve for trading is steep. A lot of people blow up their accounts along the way. Some grow impatient and dissatisfied with small gains. So they think it’s smart to use margin.
Buying stocks on margin is like playing with fire. I say this a lot: Never risk money you can’t afford to lose. If you’re using margin, odds are you don’t have enough money in your accounts to place that trade.
Sadly, for many newbies, buying on margin only increases the chance that they’ll blow up. Don’t fall for this trap.
My goal is to teach you to be a self-sufficient trader, so you can trade through any kind of market.
Frequently Asked Questions About Buying on Margin
I talk to so many traders on social media. Across all my channels, traders ask me the same questions about margin and buying stocks on margin.
To save everyone some time, I compiled some of the most frequently asked questions I’ve gotten over the last few months about buying on margin…
Is Buying on Margin a Good Idea?
In my opinion, in 99% of cases, buying on margin is a bad idea. I’ve seen far too many good traders blow up because they borrow and then let a position get out of control.
Traders can use a margin account so they don’t have to wait for their cash to settle before placing another trade. But just because you can use margin doesn’t mean you SHOULD.
How Can Traders Benefit From Buying on Margin?
Buying on margin can increase your buying power. Trading large companies is nearly impossible with a small account. Amazon (NASDAQ: AMZN), for example, trades for almost $2,000 a share. If you only have a $2,000 account, you can only buy one share of AMZN.
Using margin on well-established companies can be beneficial. Typically these companies move less than 10% a year. Using a standard margin account, those returns could be doubled.
Why Is Buying on Margin Dangerous?
It’s much easier for a stock to lose 50% of its value than to gain 100% of its value.
When buying on margin, the danger comes from the increased risks and odds of blow up. After you buy a stock on margin, you’re responsible for all the losses. Even though you technically only own half of the position.
Trade smart — avoid margin. None of my top students use margin anyway.
How Did Buying on Margin Contribute to the Great Depression?
Buying on margin helped cause Black Tuesday, which started the Great Depression. Prior to the Black Tuesday crash, people around the country were using massive margin. They sometimes used 9:1 leverage to buy stocks at inflated prices.
A lot of U.S. citizens were overconfident in the economy and stock market. Due to a large amount of margin available in the market, stocks went up too fast. That caused a bubble. When the bubble burst, it nearly crippled the entire U.S. economy.
Who Should Buy on Margin?
Only experienced traders. I’ve never used margin and probably never will. Most traders should avoid margin, especially if they’re trading sketchy penny stocks.
There’s a risk with every investment. Some people have a higher risk tolerance than others and won’t heed my advice. They’ll be the most likely to blow up their entire accounts.
I’m not a huge proponent of using margin to buy stocks. The risks far outweigh the potential returns … especially when you factor in interest and fees.
Also, I think we’re at a turning point in the global economic cycle. For the last 10 years, the world has experienced the longest bull market in history. It’s only natural that we’ll experience a pullback. In other words, buying anything on margin today is highly risky.
I know there will be some people who will bash my advice because they got lucky and doubled their account. Cool — good for you. I’m curious where you’ll be in a year.
Want to learn more about penny stocks? Check out this book by my student Jamil (I wrote the forward): “The Complete Penny Stock Course.”
Wanna learn how to adapt to any kind of market? Apply for my Trading Challenge today. My goal is to teach you to think for yourself and be a self-sufficient trader. But you’ve gotta be willing to do the work…
Tell me what YOU think of this post … does margin sound worth it to you? Leave a comment below!