You’ve undoubtedly heard of borrowing money to buy a house or a car. But Americans are also increasingly borrowing funds to invest, a practice known as margin trading.
As of this month, the “amount of money that investors are borrowing to make trades is at an all-time high — more than $1.5 trillion,” said NPR, which, impressively, is “more than the country’s total credit card debt.” But while it may sound better to invest more, there are some major risks involved, especially when someone else’s money is on the line.
What does it mean to buy on margin?
When you “buy securities on margin,” you are “able to leverage the value of securities you already own to increase the size of your investment,” said Fidelity. This investment strategy increases purchasing power, allowing investors to access opportunities they might not otherwise be able to afford. It can also “potentially magnify your returns, assuming the value of your investment rises.” Ideally, this would snowball into a “self-fulfilling opportunity cycle where increases in collateral value further increase leverage opportunities,” said Investopedia.
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How does margin trading work?
To buy on margin, you must have a margin trading account, as opposed to the standard brokerage account. Once your account is open, you will need to make an initial deposit to a broker by putting down eligible securities, which will serve as collateral, backing the amount you borrow (and allowing the broker to seize it, if needed to recoup their losses).
The broker will then float you money to buy more investments, usually “up to 50% of the initial investment capital,” said Kiplinger. So, for example, this may give you the “ability to make a $20,000 investment despite having just $10,000 funded in your account.”
As with any loan, “when an investor buys securities on margin, they must eventually pay back the money borrowed, plus interest,” said Investopedia. This cost, which gets charged to your margin account, can make it that much harder to come out ahead when borrowing funds to invest.
Why is margin trading risky?
Although “making profits with other people’s money is great,” the “problem is when markets go down,” said NPR. And just as margin trading can potentially magnify returns, it does the same for losses. It’s “even possible for a margin trader to lose more money than they originally had to invest — meaning that they would have to make up the difference with additional assets,” said Investopedia.
This demand for more money is what is known as a margin call. And as if that were not already enough pressure, “if you do not act promptly, your brokerage firm may sell securities you own — without notifying you — in order to increase the equity in your account,” said Fidelity.
