Investor's Corner

Margin Can Boost Returns, But Can Also Magnify Losses

Going on margin can amplify returns when used by a disciplined and experienced investor. Yet it can also result in big losses if used at the wrong time.

Margin is not for everyone.

It's much safer for novice investors to buy stocks strictly with cash. It can take at least two to three years for beginners to cut their teeth as they master different buy and sell rules. Like with any new undertaking, they're bound to make several bad decisions along the way.

Once they have a few years of experience, a sound plan and an understanding of strict trading rules, only then should they consider setting up a margin account.

Even then, using margin every time a promising stock crops up isn't necessarily a savvy move.

Always take into account the market's phase. Experienced investors who have been through a few market cycles should know the ideal time to use margin is during the first two years of a new bull market.

They probably also know to get off margin and raise as much cash as possible as soon as they get a whiff of a new bear market. Use the daily Big Picture, today on B2, as your guide.

"You must understand that when the general market declines and your stocks start sinking, you will lose your initial capital twice as fast if you're fully margined than you would if you were invested on a cash basis," IBD chairman and founder William O'Neil wrote in "How to Make Money in Stocks."

When an investor borrows cash from a broker to buy stocks, that's called going on margin. It can be helpful if you wish to buy more shares of a stock you're certain is the next big winner but don't have enough cash on hand.

Or it could also come in handy if you're short-selling, so you can have the liquidity available when you need it.

If you set up a margin account, you will pay monthly interest fees that are usually based on the size of the loan and vary by broker. Under current regulations, a margin account can roughly double the buying power of an investor with a cash account.

For example, let's say an investor buys 1,000 shares of a $20 stock with $20,000 in cash. If the stock goes up to $30, his profit is $10,000, or a 50% gain.

But if the investor used $10,000 in cash and $10,000 from a margin loan to buy the same stock, his profit then yields a 100% return on the $10,000 cash investment, minus the interest on the margin loan. Still, by buying on margin, he has effectively doubled his return.

It's all good when investors can double their return, as in the above example. But on the flip side, they can also lose money twice as fast as an all-cash investor if they borrow $2 for every $1 they invest.

Using the same example, if the $20 stock you purchased falls to $10, you'd be left with just the $10,000 borrowed from the broker. Before this happens, your broker might contact you with a margin call — to either deposit more money or sell stock to meet the minimum maintenance margin.

Most of the time, O'Neil says, you're better off selling stock and cutting your risk.

Also, if you're investing using CAN SLIM, you don't really need to use margin. You're going after the biggest fish in the growth pond. If you take profits on stocks that double or rise 20%, and always sell the losers at 8% or less, you can achieve a good return.