Buying Stocks on Margin

Stock market offers juicy returns to investors who are ready to take risks. If you know how to play the stock market you can make huge returns on less initial investment. Those who are in this game often look out for lucrative schemes for multiplying their profits. Buying stocks on margin is one such scheme which allows you to double your profit at half the initial investment. The whole idea of buying on margin is that you pay a marginal amount or whatever you can afford, while the lender pays the rest of it. After selling these stocks, you return the borrowed amount to the broker along with interest incurred, while enjoying the profits yourself. Trading stocks on margin involves fair amount of risk, hence it is not everyone's cup of tea. In this article, we have explain the working of buying shares on margin using an example.

Buying Stocks on Margin

When you are buying stocks without a broker you invest all the amount by yourself. In such circumstances, you can buy only as many stocks as you can afford. If the stock market is in dooms, you might want to buy as many shares as you can. However, limited cash at your disposal restricts you from doing so. Thus, you may lose out on a good opportunity. Some people consider borrowing money from their friends or financial institutions to buy more stocks. But as you must be aware, each of these options has its own drawbacks. In such circumstances, buying stocks by borrowing money may be a good stock investing option for you. In this case, the lender is a share broker or a brokerage firm, instead of a friend. You have to open a margin account with a broker with an initial deposit of $2000 to become eligible for buying on margin.

For example, if you wish to buy 100 shares of some XYZ company with a share price of $10 per share. You have to invest a total of $1000 (100 x $10) to buy those 100 shares. Let us assume that the stock market reaches a new high, so that the cost of your share becomes $12 when you decide to sell them. In this case, you make a flat profit of $2 per share, which comes to $200 (100 x $2) for 100 shares. Comparing your profit of $200 against your initial investment of $1000, your profit percentage comes to 20% (200/1000).

Now consider that you cannot raise the initial amount of $1000 and can only afford to buy shares worth $500. You choose to buy stocks on margin and borrow $500 from a broker. In this case, you are able to buy 100 shares at an initial investment of $500 only! Considering the stock market behaves in an identical manner to the above situation, you will earn a total profit of $200. However, in this case, your profit percentage will have doubled considering you only invested half the initial amount. After returning the borrowed amount with interest, you will still be in a profitable situation.

Risks

This scheme which offers stocks to buy works great when stock market is in a growing phase. However, in the opposite case, the situation can quickly turn ugly for you. When there is no broker involved, you are yourself responsible for whatever profit or loss you make. But when you let a broker invest his share, a plummeting stock market may become a cause of concern for you. Continuing with our previous example, suppose the share price now falls to $8, you face a loss of $2 per share, which amounts to a total of $200. Since, the share broker is not concerned with your losses, he will anyway demand his $500 + interest. If you sell your stocks in this condition, you will gather a total of $800. After repaying the broker, you will be left with less than $300 (800 - broker's repayment), which is far less than your initial investment.

The biggest scare when you buy stocks on margin is, you may have to face 'margin call', if you fail to repay your broker. Thus, if you are buying stocks for the first time, then buying them on margin may not be the best investment option for you.