Should I Use Margin For My Investments?
Looking for a way to turbo-charge your investment returns? Trading on margin (borrowing cash from your brokerage to invest) can be a great way to leverage your returns. But it can also materially increase your risk. It’s no wonder one of the questions I get most is — should I use margin with my investments?
As a young investor, I originally thought that there was a black and white answer to this question. When someone would ask me — should I use margin? — my direct answer would be a resounding “NO!”
My belief was that trading on margin was just too risky.
But as I’ve matured as an investor and learned more about trading and risk management, my opinion has changed. I now think that margin can be a powerful tool. But like most tools, it must be used properly and with safety precautions.
If you were to ask me today, — Should I use margin? — my answer would be “It depends.” And here are the three major issues I would ask you to consider.
Should I Use Margin? What Are You Willing To Lose?
My first instinct with all investment decisions is to manage my risk.
That doesn’t mean that I’m never going to lose money on an investment. But it does mean that I want to be aware of how much of a loss is possible. More importantly, I want to compare my risk of loss with my potential return. That way I know whether my potential return is worth the risk.
If you’re the type of investor who gets sick to your stomach when your account takes a small loss, margin probably isn’t for you.
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That’s because adding margin to your account can accentuate your losses when your investments move against you.
Here’s a quick scenario to show how margin can increase potential losses:
Suppose you have an account worth $50,000 and you invest that capital into a variety of stocks. If those stocks fall by 10%, your account value will decline by $5,000.
On the other hand, suppose you have an account worth $50,000 and you borrow an additional $50,000 on margin. You then invest the full $100,000 into a basket of stocks.
If these stocks lose 10% of their value, your investments will drop to $90,000. But you’ll still owe $50,000 on your margin loan. After repaying the loan, you’ll be left with $40,000. In other words, your $50,000 account will have sustained a $10,000 loss (or a 20% decline).
The same ratio applies to gains if your investments trade higher. So there is definitely a good side to trading on margin. But when you ask “Should I use margin?” you should be very honest with yourself about whether you’re willing to accept the risk.
Should I Use Margin? How Healthy Are Your Finances?
You should also consider your big picture financial position.
Do you currently have a job that pays you sufficient income? Do you have other investments such as real estate or precious metals? How much do you need the money in your account, and how easy would it be to replace any capital you lose?
Here’s how I think about this issue with my own finances…
I’m relatively young, in good health, with a good income. I don’t need to use the money from my investment account anytime soon. I have a house that has appreciated in value, and I have marketable skills in case I needed to get a new job or work extra hours to boost my income.
So I’m a good candidate for margin, simply because I don’t need the money in my investment account immediately. My financial condition is good. So I can afford to take more risk.
A different example might be my brother who is saving to buy his first home. He has money set aside in his brokerage account, and wants to make that money work for him. But he will need that money soon for his first down payment.
He and his wife just had their first baby, and his wife may work fewer hours in the future. Both of them also have student loans to pay off. So in this instance, margin probably doesn’t make sense for my brother.
He can still use some great income strategies to generate cash from his investment account. But he doesn’t need the additional risk that comes with margin.
Should I Use Margin? What Risk Controls Are In Place?
One of the reasons I changed my mind about margin, was that I learned more about how to manage risk.
If all of the positions in my account benefit from a rising market, that can be dangerous. In this case, if the market trades sharply lower, I could lose a lot of money. Adding margin to this scenario could be disastrous!
But if I have positions that are more balanced, with special “insurance contracts” in place, then margin makes a lot more sense.
Here’s how I currently have my account set up:
I’ve got several positions where I have sold puts for stocks that I would like to own. These positions generally do well when the broad market trades higher.
But I also have several put contracts that I have bought, to protect against the market moving lower. This “insurance contract” greatly reduces my overall risk.
That’s why I’m more comfortable using margin in my account. Because even if the market trades sharply lower, I’ve got much less risk of getting hit with a major loss.
I’d love to hear what you think about margin. I’ve found that this can be a very polarizing subject. So it wouldn’t surprise me if you have a very different opinion!
Whether you agree with me, or you think I’m way off base, I’d love to hear your answer to the “Should I use margin?” question.