Investing in the financial markets offers individuals the opportunity to grow their wealth and achieve financial goals. One strategy that investors often consider is buying on margin. This approach involves borrowing funds from a broker to purchase securities, allowing investors to potentially amplify their returns. However, buying on margin comes with its own set of benefits and risks that individuals need to understand before venturing into this investment strategy.
We have prepared this guide to shed light on buying on margin definition, its advantages, disadvantages, and the potential risks involved. The ultimate goal is to provide a comprehensive understanding of this investment approach so you can decide whether to incorporate it into your investment activities.
In this guide
Buying on Margin: Benefits and Risks
What Is Buying on Margin?
Buying on margin is an investment strategy where an investor borrows funds from a broker to purchase or trade securities such as stocks, bonds, commodities, cryptocurrencies, and more. It allows investors to leverage their existing capital, enabling them to acquire more shares or securities than they could afford with their own resources alone. By using borrowed money, investors aim to amplify potential returns.
The borrowed amount acts as a loan, which investors are required to repay with interest over time. Buying on margin offers the opportunity to generate higher returns if the value of the securities purchased increases. However, note that buying on margin can also amplify losses. If the securities’ value declines, investors lose their initial investment and remain liable for the borrowed funds, potentially leading to substantial losses and margin calls.
Overall, margin trading requires careful consideration of the associated risks and diligent monitoring of investment positions.
How to Buy on Margin
To buy on margin, you need a legit broker featuring this investment strategy and your preferred instruments. Remember, brokers vary, so you must conduct extensive research to identify the one that will maximise your experience. Then, follow the steps below to buy an asset on margin.
- Open a Margin Account: The first step in this process is opening a margin investment account with a broker that offers this trading service. Note that most top FCA-regulated brokers in the UK have a straightforward account registration process that takes a few minutes to complete.
- Meet the Initial Margin Requirement: With your already set up investment account, you must meet a broker’s minimum initial margin requirement to use this feature in your investment. This requirement is usually a percentage of the total value of the securities you wish to purchase.
- Place an Order: Once your margin account is set up and funded, you can place an order to buy the desired securities. Specify that you want to buy on margin and indicate the number of shares or the value of the securities you wish to acquire.
- Monitor Your Position: Keep a close eye on your investment position as market conditions change. Remember that margin trading carries additional risks, considering that you are investing using brokers’ borrowed funds. If you are not keen, you could end up accumulating huge losses.
Buying on Margin Example
To ensure you fully understand how buying on margin works, let’s take a look at buying on margin example below.
Suppose you have £5,000 in your margin account and want to purchase shares of a company’s stock trading at £50 per share. With a 50% initial margin requirement, you can buy up to £10,000 worth of the stock (twice your available funds). You buy 200 shares using £5,000 from your account and borrow an additional £5,000 from your broker.
Now, let’s say the stock price increases to £60 per share. If you sell all 200 shares at this price, you will receive £12,000. After repaying the £5,000 borrowed from the broker, you are left with £7,000. Subtracting the initial £5,000 investment, your profit is £2,000, 40% of your initial investment.
In this example, buying on margin allows you to amplify your returns by leveraging borrowed funds. However, note that if the stock price declined, your losses would have been magnified. That is why we highly advise investors to be fully confident in their skills and strategies before buying an asset on margin. Most importantly, consider investing with amounts you are comfortable losing to avoid getting emotionally frustrated in case of a loss.
Advantages and Disadvantages of Buying on Margin
The main goal of buying a financial instrument on margin is to magnify profits. However, this investment strategy also falls short in specific categories. We explain below the pros and cons of buying on margin so you can decide whether you can incorporate it into your investment activities.
Pros
- Increased Buying Power: Buying on margin allows investors to leverage their existing capital, giving them access to a larger pool of funds for investment. This increased buying power enables them to purchase more shares or securities than they could afford with their own resources alone. By leveraging borrowed money, investors can potentially increase their investment opportunities and participate in larger-scale trades.
- Enhanced Returns: Many investors also prefer buying securities on margin due to its potential for amplified returns. If the securities purchased with borrowed funds increase in value, the profits earned will be based on the total investment, including the borrowed amount. As a result, you get to generate higher returns than investing solely with your own funds.
- Diversification: Margin trading allows investors to diversify their portfolios more effectively. With increased investment capital, you can allocate funds to a broader range of investments, spreading the risk across different assets. Diversification is a fundamental strategy for managing risk and can help protect against substantial losses in case of any unforeseen downturns in specific sectors or companies.
- Flexibility and Liquidity: Buying on margin provides investors greater flexibility and liquidity. It allows them to seize investment opportunities promptly without waiting for funds to become available. Margin trading also allows investors to quickly access their capital if they need to seize other investment opportunities or address any financial obligations.
Cons
- Margin Calls: One of the significant risks associated with buying on margin is the potential for margin calls. When the value of securities purchased with borrowed funds declines, a broker may require an investor to deposit additional funds to maintain the minimum required margin.
- Increased Losses: While buying on margin can amplify gains, it can also magnify losses. If the value of the securities declines significantly, the investor not only loses their initial investment but also remains liable for the borrowed funds.
- Margin Fees: When an investor borrows funds for margin trading, they are required to pay interest on the borrowed amount. These interest expenses can eat into potential profits and increase the breakeven point for investments.
Risks of Buying on Margin
Although buying on margin has proven beneficial to investors, it carries specific risks you should be aware of. Let’s explore some of the risks associated with margin buying.
- Loss Amplification – As mentioned earlier, buying an asset on margin can magnify losses if an investment doesn’t work out as expected. Understanding this element will help you plan your activities and invest with amounts you are comfortable losing.
- Margin Calls – Another risk of buying on margin is the potential for a margin call. Suppose the value of securities purchased with borrowed funds declines. In that case, your broker may issue a margin call, whereby you are required to deposit additional funds to maintain the minimum required margin. Failure to meet this broker’s requirement can lead to the forced sale of securities at potentially unfavourable prices.
- Psychological and Emotional Factors – Margin trading can introduce psychological and emotional factors affecting investment decision-making. The pressure to meet margin requirements and the potential for significant losses can lead to impulsive or irrational trading decisions. Maintaining a disciplined approach and a well-defined investment strategy to mitigate emotional biases is essential.
- Regulatory and Policy Changes – Margin trading is subject to regulatory guidelines and policies that may change over time. Changes in margin requirements or regulations can impact long-term investors’ borrowing capacity and margin maintenance obligations. It is essential to stay informed about regulatory changes affecting margin trading and adjust investment strategies accordingly.
FAQs
Buying on margin allows investors to amplify their potential returns by leveraging borrowed funds, which can lead to increased profits if the investment performs well. It also allows you to easily diversify your investment portfolio since you have more investment capital.
Buying on margin involves borrowing funds, thus increasing potential gains and losses. If the market moves against the investor, the borrowed funds can result in significant losses and potential margin calls.
Yes. Margin buying can be suitable for experienced investors who thoroughly understand the risks involved and can actively monitor their investments. However, this investment strategy is not recommended for novice investors or those with low risk tolerance.
The initial margin requirement varies depending on the broker and the securities being purchased. It is usually a percentage of the total value of the securities, typically ranging from 25% to 50%. You should consider your budget when considering investing on margin.
Absolutely. Stocks are one of the common types of securities that investors can buy on margin. However, the availability of margin trading and the specific requirements may vary depending on a broker and local regulations.
Conclusion
Buying on margin can be a powerful tool for investors to enhance their investment opportunities and potentially generate higher returns. However, it is essential to approach margin trading cautiously and fully comprehend the associated benefits and risks. You should conduct thorough research, evaluate your risk tolerance, and establish a well-defined strategy before engaging in margin trading.
If you are a newbie to margin investment, find a suitable broker and start with small amounts until you are ready to risk more money. The good news is that most FCA-regulated margin investment brokers have a wide selection of learning resources for skills development. Plus, the brokers offer a demo account you can gauge your skill level before putting up real money in an investment.
25,000 hours of testing 70+ brokers. Our recommended broker is Plus500.
Our recommended broker is Plus500.