Ask a Fool: How Does Buying Stocks on Margin Work?

Q: I recently opened a brokerage account, and I see a "margin buying power" that is much higher than the amount I deposited. How does buying stocks on margin work?

When you open a brokerage account, you are typically asked whether you'd like a cash account or margin account. Cash accounts only let you use the money you deposit to invest in stocks, while margin accounts allow you to borrow money against your account. In other words, if you want to buy $5,000 worth of a particular stock, but only have $4,000 in available cash in the account, you can use margin to borrow the other $1,000.

There are several potential advantages to using margin. Most obviously, it allows you to buy more shares of stock than you would otherwise be able to, which could increase your investment returns or add diversification to your portfolio. Another consideration is that if you want the ability to sell a stock short, you're required to have a margin account. Finally, margin gives you a line of credit, in the sense that you could borrow against the investments in your account if you ever find yourself strapped for cash.

However, there are a few downsides as well. First and foremost, when buying stocks on margin, you could potentially earn higher returns if the stocks go up, but you can also lose more if the stocks go down. In fact, in a stock market crash, using margin makes it possible to lose more money than you have if your stocks perform poorly.

You'll also pay interest on a margin loan (rates are currently around 8% at most brokers), so you'll need to earn returns of this much or more on investments bought on margin just to break even.

While it could be a smart idea to choose a margin account for its extra privileges and the ability to borrow money if you need it, buying stocks on margin is generally a bad idea for most everyday investors and is best left to professional and highly experienced traders.

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