Possible Outcomes of Stock Investments Made on Margin
Suppose you think that the stock for the company Mergatroid, Inc., currently at $40 per share, will go up in value. You want to invest in 100 shares, but you have only $2,000. If you’re intent on buying 100 shares (versus simply buying the 50 shares that you have cash for), you can borrow the additional $2,000 from your broker on margin.
If the stock price goes up
This outcome is the best for you. If Mergatroid goes to $50 per share, your investment is worth $5,000, and your outstanding margin loan is $2,000. If you sell, the total proceeds will pay off the loan and leave you with $3,000.
Because your initial investment was $2,000, your profit is a solid 50 percent because your $2,000 principal amount generated a $1,000 profit. However, if you pay the entire $4,000 upfront without the margin loan, your $4,000 investment generates a profit of $1,000, or 25 percent. Using margin, you double the return on your money.
Leverage, when used properly, is very profitable. However, it’s still debt, so understand that you must pay it off eventually, regardless of the stock’s performance.
If the stock price fails to rise
If the stock goes nowhere, you still have to pay interest on that margin loan. If the stock pays dividends, this money can defray some of the margin loan’s cost. In other words, dividends can help you pay off what you borrow from the broker.
Having the stock neither rise nor fall may seem like a neutral situation, but you pay interest on your margin loan with each passing day. Margin trading can be a good consideration for conservative investors if the stock pays a high dividend. A high dividend from $4,000 worth of stock can exceed the margin interest you have to pay from the $2,000 you borrow from the broker.
If the stock price goes down, buying on margin can work against you. What if Mergatroid goes to $38 per share? The market value of 100 shares is then $3,800, but your equity shrinks to only $1,800 because you have to pay your $2,000 margin loan.
You’re not exactly looking at a disaster at this point, but you’d better be careful, because the margin loan exceeds 50 percent of your stock investment. If it goes any lower, you may get the dreaded margin call, when the broker actually contacts you to ask you to restore the ratio between the margin loan and the value of the securities.