This strategy is similar to long common stock, but on steroids. That’s because when buying stock on margin you normally put up only half of the money to purchase the stock and borrow the other half from your broker. Although the benefit of trading on margin is a boost to your available trading capital, there are costs and risks. In return for the loan, you must pay your broker interest, and the percentage of interest charged is referred to as the “margin rate.” The main risk is, if the stock declines sharply, you can lose more than your initial investment.
When you buy stock on margin, obviously you’re hoping that the firm will be profitable and you’ll share in the benefit of those profits. If you own a dividend-paying stock, you’d like to receive juicy dividends and you’d like to see a nice (if not spectacular) increase in stock price after a while. Some investors feel the higher the dividend, the less they are concerned with increasing share price over time, since they are already receiving income from owning the stock. If you own a non-dividend-paying stock, then any gains you could receive would ultimately come from an increase in the stock’s price. The caveat here is your margin interest cost will cut into your potential profits and the cash flow of any dividends you may receive.
This might seem like a most simplistic play, but it’s rendered fairly complex by the simple fact that picking winning stocks is difficult. This is magnified by the leverage and risk which comes from trading on margin. The best way to go about choosing winning common stocks has mystified, confounded and befuddled investors for as long as stocks have been traded. Furthermore, the markets don’t behave in what appears to be a rational manner. You might see stocks grow profits or beat earnings estimates and still decline in the long run. Nevertheless, on Wall Street, you can’t appeal the outcome of your trades. As the old saying goes, “The market may not always seem to be right, but it is never wrong.”
You can think of this strategy as magnifying your skill level. If you are a consistently profitable trader or investor, owning common stock on margin can possibly give you even better returns. That said, if you usually don’t do very well, running this strategy could leave you with terrible consequences. If you don’t consistently do well with your trades or investments, perhaps you’d better leave this strategy alone and consider running plain old long common stock in cash.
Before you borrow money from TradeKing to own common stock on margin, you must be approved for a margin account. Please note margin trading for equities is not permitted in retirement accounts because of SEC restrictions.
Buying common stock on margin is a leveraged play, designed to double the potential return on investment (ROI) for each dollar you spend on the stock. Of course, doubling your potential ROI sounds great in theory, but you must remember there is an equal downside. In this case, your potential losses are also doubled, which can exceed the amount of your investment.
Here’s a (somewhat simplified) example. Imagine you want to buy 100 shares of a $50 stock on margin. Normally, that would cost you $5000. However, when you run this strategy, you only need to pay $2500 up front and borrow the other $2500 from TradeKing. If the stock goes up $5 to $55, it has increased 10%. However, since you only put up half of the money to buy the stock, your ROI is actually 20%. Conversely, if the stock goes down 10% from $50 to $45, your ROI is actually -20%. If the stock goes to zero, your maximum risk is -200%.
The math in the previous example is somewhat simplified because it doesn’t take into account the interest you must pay your broker to borrow half of the money to buy the stock. Imagine the example was a position trade and it took exactly three months to see the 10% increase in share price from $50 to $55. Since you bought 100 shares on margin, your holdings would have increased by $500.
But let’s say your broker’s margin rate is 6%. That means over the three months you held this position, you would have paid $37.50 in interest on the $2500 you borrowed. You must then deduct that $37.50 in interest from the $500 profit you made on the trade. In other words,you’d have given up 7.5% of your profits in the form of interest paid to your broker. Nevertheless, you have made profits of $462.50 ($500 - $37.50) on your initial investment of $2500, which is an ROI of 18.5%, compared to the 10% ROI you would have achieved if you paid cash for the stock.
You also need to factor in any commissions paid to your broker. If you did this trade at TradeKing, it would cost you $4.95 to enter the trade and another $4.95 to exit, so your final profit would be $452.60 ($462.50 minus a total of $9.90 in commissions). That would further reduce your overall return on investment to 18.1%.
When you are long common stock in cash, you know in advance exactly how much you stand to lose: namely, your cost basis. You’ve already paid for your potential losses up front when you bought the stock in cash. When you own common stock on margin, however, you remain on the hook for cash you’ll need to come up with later if the stock’s value declines. Here’s the real hitch: you can lose more than your initial investment.
The best way to deal with these sticky and potentially painful scenarios is to determine in advance just how much you’re willing to add to your cash or marginable securities (see Margin Requirements). If you do run into trouble, you’ve drawn your proverbial line in the sand and you’ll know to get out before things get worse.
Long common stock on margin is a play that can be run across all time frames. However it tends to be run as a shorter-term trade, because it involves paying interest on money borrowed from your broker. Your time horizon may vary according to your investment objectives, skill level, risk tolerance and available capital. If you are planning on a short-term trade and it isn’t working out, don’t give it extra time to perform. Get out according to your schedule and go on to the next trade. If you find yourself saying, “I’ll give it just one more week,” you’re probably guilty of breaking this rule.
When to Get In
You might consider buying long common stock on margin if:
- The stock is already on the rise, generally speaking. It’s usually a bad idea to pick a stock that’s on the decline with the intention of hitting the very bottom of a downswing, because it’s nearly impossible to pick the bottom.
- Fundamental analysis shows the financial health of the company is sound.
- There are bullish technical indicators setting up for your stock.
- Company insiders are purchasing shares in large quantities.
- There are positive rumors about an upcoming news announcement (earnings, for example) that’s anywhere from two to six weeks in the future.
- Using sector rotation, the company is in a sector or industry poised for growth coinciding with the next phase of the economic cycle.
Wall Street is not a laboratory, so analysis is not done in a vacuum. Feel free to combine methods to help you get in at the most opportune time you can determine.
Last but not least, try to avoid acting on tips you might hear around the proverbial water cooler. By the time Joe Public knows about a pending stock rise, it’s usually old news
When to Get Out
Long stock holders on margin might sell their positions based on any of the following:
- You’ve reached your profit target. Don’t get greedy. Get out before the stock reverses.
- You’ve hit your figure for how much you’re willing to add to your cash or marginable securities. Get out before the trade spins out of control.
- Your predetermined stop-loss has been triggered.
- Fundamental analysis shows the financial health of the company is under fire and is no longer on solid footing.
- There are bearish technical indicators setting up for your stock.
- Company insiders are selling shares in large quantities.
- Before earnings are released (or before some other upcoming event that’s been creating a wave of downward momentum).
- Using sector rotation, the company is in a sector or industry expected to face challenges in the next phase of the economic cycle.
- There are upcoming events that might generate negative news.
- You’ve given the stock adequate time to perform, and it’s not demonstrating much in the way of bullish activity. Stick to the planned timeframe.
Anytime you enter a trade, you are obviously expecting the results to be outstanding. But as you know, that will not always be the case. Even the most carefully chosen trade can go south in a hurry. Because you are increasing your risk by trading on margin, you must keep this trade on a short leash.
Long common stock on margin is a higher-maintenance play that requires a lot of discipline. Whenever you trade on margin, you need to keep a close eye on the market. Be prepared to put in significant time managing this trade, and don’t get in unless you can handle the added risk.
Just because you’re in the trade, it doesn’t mean your hard work is over. It’s just begun. If any of the analysis used to get into your trade shows signs of trouble, take action to reduce or exit your position, if warranted. You’re responsible for knowing the timing of upcoming earnings announcements and dividend actions. Be sure to check news for the symbol you’re trading in case a merger, spinoff, major lawsuit or the like is announced. It’s important that you thoroughly understand all of the news related to your stock, which is sometimes no small feat.
You need to have a trading plan and stick to it. This involves evaluating your capital for investment or trading purposes, your personal trading style, and your stomach for risk tolerance. There are two considerations most trading plans include. The first is how much is the maximum amount you should invest in a particular stock. The other is the maximum stop-loss percentage. Remember to follow your trading plan not just at the beginning of a trade, but also in the middle of one.
Although it can be tempting to use margin to double your typical investment, by doing so you could be setting yourself up to compound your normal losses due to leverage. Especially if you’re a beginning trader, it’s critical to understand the risks and not get in over your head. Abide by the amount your trading plan allows, regardless if you own common stock on margin or in cash.
Scaling in and out is an approach planned in advance for getting in and out of a trading position in phases instead of all at once. This appeals to traders who don’t want to rush in (or out) of any investment. Consider “pyramiding up” to buy more when you’re right, but avoid “averaging down” or “doubling down” when you’re wrong. Obviously, the more frequently you trade, the more transaction costs you will incur.
The good news is you don’t always have to be right if you stick to a stop-loss plan. Let’s say you pick ten stocks. Seven might be losers, but if you stick to a predetermined stop-loss you can avoid major catastrophes. Then trades eight and nine might be small winners, and the tenth could be a big winner that puts you into the black even with the seven losses.
Of course, that makes the assumption that you are able to stick with the big winner without getting excited and cashing in early. The less likely you are to stick with your winners, the better you need to be at picking your stocks. The key is simply to have a predetermined trading plan and stick to it without fail, which is sometimes easier said than done.
It’s important to set realistic goals. If a stock has shown a nice rally and then begins to peter out and show signs of a downturn, don’t get greedy and hope the rally will resume. If you’ve hit your predetermined goals, take the money and run. Far too many traders give back a big chunk of their gains before realizing a downturn isn’t temporary. This is especially true for this play because your potential gains and losses are sharply increased when trading on margin.
Conversely, if you’ve picked a major winner and all the indicators are still bullish, don’t get overexcited and cash in your chips. If the stock takes a little dip, but all indications are for a return to higher prices, don’t abandon ship just yet. Just be sure you have accounted for acceptable volatility in stock price in advance, and if it starts to dip beyond that range by all means get out. Feel free to exit piecemeal, as the situation dictates.
It can’t be overemphasized that you must approach every trade with a predetermined stop-loss. Some traders think somewhere around 5-7% is an acceptable range, depending on the volatility of the stock. Because your potential losses are compounded, you must be extremely disciplined about sticking to your personal stop-loss rules. If your stop-loss is about to be triggered, or you’re nearing your personal margin limit, don’t give the trade more room to go against you. If you reach your stop-loss, get out. Don’t start to rationalize about why the stock might make a turnaround. Exit the trade and focus your attention on finding better places to invest your money. However, please note if you enter a stop order or stop limit order, this will not protect you from gap risk if the stock opens down sharply overnight or if trading is choppy or halted during the day. Gaps may result in losses in excess of your predetermined amount.
Each stock has a figure known as its “beta.” This is the percentage that the stock price is expected to rise or fall as its benchmark index (commonly the S&P 500) rises or falls 1%. If stock XYZ has a beta of 1.5, then it will be expected to go up 1.5% if the S&P 500 rises 1%, or fall 1.5% if the S&P 500 goes down 1%. That means it is 50% more volatile than the market at large. Knowing your stock’s beta can give you some indication of its volatility compared to the broader market.
Some stocks are more volatile than others. How much fluctuation you’re willing to allow to the downside depends on the volatility of the stock. For instance, you may be willing to tolerate a 7% dip in an internet high flyer as opposed to a 5% dip in a venerable blue-chip stock.
Although it’s all fine in theory to agree to a potential decline in stock price, it can be rather nerve-wracking watching a stock decline by 7%, especially when you’re trading on margin and that actually equals a 14% loss, plus whatever interest and commissions you’re paying. When you see the actual change in dollar value, you might be tempted to get out early before giving the stock a chance to recover.
If it really looks like you’re going to hit your stop-loss, it’s sometimes OK to bail early. But don’t waste time second-guessing yourself if the stock rebounds later. You can only act with the best information available to you at that time. On the other hand, don’t be stubborn if you’re wrong. If it looks like your trade is a loser, get out, never look back, and stop getting quotes on it.
TradeKing Margin Requirements
Obviously it’s important to estimate in advance how much margin interest you expect to pay on every margin trade because you’ll need the stock to outperform these costs. Margin rates vary from account to account. The more you borrow, in general, the lower the rate may be. You can view the lower rates as a volume discount.
If you understand the risks, you can buy long common stock on margin as long as you have a margin account which meets the minimum equity requirement of $2,000. Not all stocks may be purchased on margin. For stocks above $6.00, the initial margin requirement is usually 50% of the purchase price and the maintenance requirement is usually 30% of the current value. These requirements could increase due to market volatility, fluctuations in the stock’s value, concentrated positions, trading illiquid or low-priced securities and other factors.
If the equity in your account is not sufficient to meet these requirements, you will be required to increase your cash or marginable security holdings to ensure you have sufficient collateral to repay the loan. When this happens, it’s known as a “margin call,” and TradeKing will instruct you to adjust your holdings over the life of the trade. If all this is too much to handle, consider running long common stock instead.