Elias Zeekeh, MBA, CPA, CMA
Pros and Cons of Margin Trading
Should you invest on margin? The answer is not a straightforward one, and there are both pros and cons. Ultimately a decision should be made based on your individual investment goals. Below are some general thoughts:
A margin account allows you to purchase more stock than you have cash in your account. For example, say you want to buy shares in company A whose shares are trading at $100 and you have $10,000 in in your trading account. With a cash account you could purchase exactly 100 shares assuming no trading fees. But if you have a margin account you could purchase 200 shares if the stock had a 50% margin requirement, allowing you a greater return if the stock price of the company goes up. The minimum margin requirement is set by securities legislators in your jurisdiction, and then individual brokerages set requirements in excess of the minimum at their discretion. Having a margin also provides the opportunity to implement a full range of option and short selling strategies which require a margin account.
The downside of utilizing margin is that if stock prices go down you will have greater losses, and the same leverage that can help you on the upside will hurt you on the downside. Additionally, if stocks go down enough your brokerage will eventually require you to deposit cash into your account or to sell stock to free up margin space. You will also be paying interest on borrowed funds, and it’s important to take this into consideration when making trading decisions. Your incremental return needs to be in excess of the margin interest to make the trade worthwhile.
In conclusion, trading on margin could be worth it for you depending upon your investment goals and risk tolerance. If you do you will need to ensure that you don’t over-leverage and provide yourself with an adequate margin of safety such that you don’t have a margin call. Under most circumstances I’d suggest not owning more than 1.5 times the balance of your account in stock. If you are carry mostly eligible securities with a margin requirement of 30 percent (assuming your broker doesn’t have any special requirements) you should be able to withstand a market drop in excess of 30 percent without triggering a margin call.