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basic idea behind margin investing is rather simple. Rather
than having to put up all the cash needed to buy a stock,
an investor can pay only part of the price and borrow the
rest of the money.
Typically the interest rate on a margin loan is much lower
than someone would pay on a credit card for example, because
the money that is loaned is secured by the existing funds
in the account. Interest rates on margin loans can vary by
as much as 3 percentage points and you are permitted to borrow
up to 50% of the value of your stocks.
Doing
some simple calculations can help one understand how investing
on margin increases both potential profits and risks. If an
investor buys a $10,000 worth of stock and it rises to $20,000,
an investor has now doubled their money. Now if the investor
used $10,000 to buy $20,000 worth of stock, ten of which being
borrowed on margin and the shares doubled, then $40,000 would
result. After paying back the broker the $10,000 margin loan
plus commissions, you now have made approximately $30,000.
The original investment has tripled. Sounds great!
Here
is the downside. If an investor bought $10,000 of stock and
it dropped to in value to $7,000, the loss would be $3,000,
or 30%. However, if $20,000 of stock was bought with $10,000
being on margin, and the same loss occurred, one would be
left with stock worth $14,000. After repaying the $10,000
margin loan an investor is now left with $4,000.
What
was a 30% loss with a traditional investment has now turned
into a 60% loss buying on margin. Quite a substantial difference!
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