The short answer
Buying stocks “on margin” is a loan from the broker to the investor which allows the investor to buy more stocks or a larger number of shares of the same stock. The borrower must pay interest on the loan.
It requires a special investment account with your broker called a Margin Account and is intended for specialists who are very experienced and trade frequently, for example, day traders.
The advantage is leverage that can result in increased profits for the trader.
But this also increases Risk.
There is the potential for significant downside if the value of the shares purchased decreases.
When that occurs, the broker will make a “margin call” to the trader. This means the trader must come up with the difference in value quickly, frequently overnight, but could even be same day.
Real Life Example
A friend of ours is a very experienced trader. He was not a trader by profession. He had a very good job in a large company.
Because of his experience and success, his Margin Account had grown. Then Black Monday happened.
No one was expecting the very sudden, deep dive the Market took dropping 22% in one day.
Like many others, he received a margin call.
In his case he had to make up the $400,000 decline in the value of his investments within 24 hours.
He had to sell all of his stock, empty his savings account and borrow the rest to meet the call.
To pay off the money borrowed, he had to liquidate a large part of his 401(k) incurring significant penalties.
His real cost was well beyond the $400,000 call and it took him years to recover!
Buying on margin is buying using borrowed money!
There are risks that are seen and there are risks that are unseen or unanticipated. But there is always risk.
The average DIY investor would not likely be using a Margin Account.
“Risk management has many names. It was the very first concept Bill Eckhardt addressed in class and ultimately the most important.”
From The Complete TurtleTrader: How 23 Novice Investors Became Overnight Millionaires” by Michael Covel.
I am not a big believer in ‘overnight millionaires’ but I do believe in “go slow to go fast”. Smart Work by Lisa Marshall.
And I am 100% convinced that managing risk can lead to greater wealth.
Remember: Ride Your Winners; Cut Your Losses!
