Margin is simply the act of borrowing money to purchase securities. When an investor uses margin in the stock market, it means that he only pays a percentage of the stock’s value, while the balance comes from borrowing from the broker or bank. Most often, the broker plays the role of a lender by using the balance in the account for the securities as collateral on the loan’s balance. The amount deposited by the buyer is the margin, and it is usually expressed as a percentage.
Margin involves the use of leverage. This means you are controlling a certain amount of a security with a smaller amount of capital. Leverage will amplify your gains. However, it will also make your losses larger.
Margin is always used by investors that expect to earn a higher rate of return on the investment than the interest payable on the loan. A broker will require prior approval before you can trade stocks on margin.
Investors planning to use margin as one of the several strategies in the stock market should think about the following factors. This list does not contain everything to consider, but it is a good starting point:
There is always an interest chargeable on the borrowed or leveraged amount. The rate may vary based on the overall portfolio value; that is why you should check with your broker.
Be careful with upcoming news about earnings when you are holding a position on margin. Many investors buy more stock believing that there is positive news around the corner, but what if the opposite happens?
Margin calls compel the investor to either deposit more fund to offset losses incurred on the margin or sell a position held entirely. There is a certain price level where once reached a margin call will take place. Make sure to know this area before buying or holding a position.
Prevent margin calls and taking bad losses by using stop loss orders. It is like an insurance policy against bad losses and marginal calls.
Be cautious and have a backup fund in case something undesired happens.
Have a game plan and stick to it.