When investors have had some success with their strategies, they often want to alter those winning strategies to possibly make even more money. However, it is common to run into a simple, yet tough, barrier at this point: a lack of funds for further investing. That’s when many ask themselves, “How can I get more trading leverage?”
One way to get more leverage is to set up a margin account. These accounts use a portion of the stocks within them as collateral for what are called margin loans. Such loans are made by brokerage firms for the purpose of buying more stock. As with other investment instruments and strategies, there are both risks and benefits that go along with this strategy.
Margin accounts amplify the results of any trading strategy. This makes the use of margin accounts riskier than typical, straightforward buying and selling. With a margin account, the broker must be paid back the entire amount of the loan even if the stock price drops. Just as importantly, the value of the collateral stock can also drop. When this happens, investors must replenish that stock or pay down the loan to keep everything within the agreed-upon limits. Such events can cause the investor to be forced to sell into a down market, losing even more money than the original amount invested, before everything settles.
The same amplification effect that increases risks also increases potential benefits. This is why many investors use margin accounts even if they can afford to pay cash. One can increase profits with margin account funding because the broker only has to be repaid the original loan amount even if the prices of the stocks soar. Investors thereby end up with far more profit than would otherwise be possible under these circumstances.
Other benefits are much the same as those that arise from loans in general. With more money available, investors can buy stocks that would otherwise be out of reach. An improving portfolio with margin account funding can therefore be more diversified than would normally be possible.
Are Margin Accounts Worth the Risk?
There is no one risk profile that fits everyone, so it’s impossible to make a blanket statement. The main thing to remember is that it’s possible to lose 100 percent of the money that is at stake in a margin account. This risk can be mitigated by various strategies for separating essential funds from non-essential ones, avoiding taking out overly-large margin loans, and similar practices.
The other important thing to remember is that everyone has a different psychological tolerance for risk and drive for reward. One person may find the maximization of potential benefit to be the key factor in his or her decisions, while another may want to minimize risk as much as possible. These different drives will require different investment strategies to meet them.
Usually, many investors will find margin accounts worth their risk as long as basic, common-sense practices are used. Avoid the temptation to go “all in” during heated market shifts. Instead, calculate everything wisely so that the risks won’t outweigh the potential rewards.