The benefits of margin
The benefits of margin
When used for investing, margin can magnify your profits—and your losses. Here's an example of the potential upside. (For simplicity, we'll ignore trading fees and taxes.)
Assume you spend $5,000 cash to buy 100 shares of a $50 stock. A year passes, and that stock has risen to $70. Your shares are now worth $7,000. You sell and realize a profit of $2,000.
A gain without margin
You pay cash for 100 shares of a $50 stock: -$5,000
Stock rises to $70 and you sell 100 shares: $7,000
Your gain: $2,000
Here's what happens when you add margin into the mix. As we saw above, $5,000 in cash gives you buying power totaling $10,000—your existing cash, plus another $5,000 borrowed on margin from your brokerage firm—allowing you to buy 200 shares of that $50 stock.
A year later, when the stock hits $70, your shares are worth $14,000. You sell and pay back $5,000, plus $400 of interest,1 which leaves you with $8,600. Of that, $3,600 is profit.
A gain with margin
You pay cash for 100 shares of a $50 stock: -$5,000
You buy another 100 shares on margin: $0
Stock rises to $70 and you sell 200 shares: $14,000
Repay margin loan: -$5,000
Pay margin interest: -$400
Your gain: $3,600
So, in the first case you profited $2,000 on an investment of $5,000 for a gain of 40%. In the second case, using margin, you profited $3,600 on that same $5,000 for a gain of 72%.
The risks of margin
Margin can magnify profits when the stocks that you own are going up. However, the magnifying effect can work against you if the stock moves the other way as well.
Imagine again that you used $5,000 cash to buy 100 shares of a $50 stock, but this time imagine that it sinks to $30 over the ensuing year. Your shares are now worth $3,000. If you sell, you've lost $2,000.
A loss without margin
You pay cash for 100 shares of a $50 stock: -$5,000
Stock falls to $30 and you sell 100 shares: $3,000
Your loss: -$2,000
But what if you had borrowed an additional $5,000 on margin and purchased 200 shares of that $50 stock for $10,000? A year later when it hit $30, your shares would be worth $6,000. If you sold for $6,000, you'd still have to pay back the $5,000 loan and $400 interest, leaving you with only $600 of your original $5,000—a total loss of $4,400.
A loss with margin
You pay cash for 100 shares of a $50 stock: -$5,000
You buy another 100 shares on margin: $0
Stock falls to $30 and you sell 200 shares: $6,000
Repay margin loan: -$5,000
Pay margin interest: -$400
Your loss: -$4,400
If the stock had fallen even further, you could theoretically lose all of your initial investment and still have to repay the amount you borrowed, plus interest.
