Last Updated on December 2, 2024
Overview – The Never-Ending Search for Better Returns
As the cost of living continues to slowly creep up, and as new goods and services continue to be unveiled on a regular basis, it’s no wonder that many investors are constantly looking for new ways to help boost their returns in order to meet the increasing financial demands of their lives.
There are a variety of ways to accomplish this: concentrating your holdings, choosing to pursue certain high-return investment instruments, and establishing anchor investments are all possible solutions.
However, there exists another method: margin trading. In other words, using borrowed money for investment purposes.
Although margin trading has been used by countless investors over the years to help them get the returns they want, it’s very important to understand (and just as easy to overlook) that it is a double-edged sword: utilize it correctly and you will achieve very strong returns, but be reckless with it and you’ll soon find yourself dealing with a very big problem.
The Theory Behind Margin Trading
As was discussed in the Financial Statements article, the balance sheet is dictated by a simple equation, widely known as the accounting equation:
Total Assets = Total Liabilities + Total Equity
We also discussed that this equation means there are two ways companies can get their hands on assets: by using their own funds (equity), by using debt (liabilities), or some mix of both.
Similarly, investors have two ways to purchase investments: by using their own capital (primarily through cash), by using leverage (i.e., borrowed money), or a mix of both.
Margin trading is when an investor uses leverage for investment purposes, whether they use it to supplement whatever cash they have, or to finance their investment purchases entirely (in practice, however, this is very rare to see).
Naturally, since you’re using borrowed money, you will need to repay your outstanding debt as well as any interest it may have accrued. How this affects your returns will be looked at in a later section.
So, how exactly can margin trading boost returns, or if things go poorly, amplify losses?
How Margin Trading Boosts Returns
Say you want to purchase some stock, and the price per share is $100.
Let’s say you decide to purchase 10 shares using cash, making your total purchase price $1,000 (for the sake of simplicity, the commission is assumed to be $0). A year later, the price of the stock increases to $125, meaning the value of the shares you own is now $1,250.
You decide to sell, and in doing so you net a profit of $250 (again, the commission is assumed to be $0). Therefore, your return on capital is 25%.
Now, imagine that, instead of financing this purchase entirely with cash, you use only $500 in cash, and the remaining will be on margin (that is, you use $500 of borrowed money). Just like the previous scenario, the share price increases to $125.
Again, the market value of the shares still goes to $1,250, but remember that of this amount you must repay the principal of your debt ($500), as well as any interest it has accrued (assuming a simple interest rate of 8%, the interest owing is $40).
Therefore, your remaining proceeds from the sale will be $710, leaving you with a return on capital of 142%.
What makes margin trading so potentially powerful is that your return on capital could theoretically be infinite. This can be accomplished by putting up less of your own cash and using more leverage.
In practice, however, this may not be possible. Many brokerages place a limit on how much of your purchase can be made using margin. For example, some brokerages may only allow their clients to use margin financing for up to 50% of the purchase price. If you plan to make real estate investments using a mortgage, you’ll need enough cash on hand to satisfy the down payment requirement – zero down payment purchases are possible but rare.
How Margin Trading Magnifies Losses
As was mentioned in the introduction, margin trading is a double-edged sword, meaning that it can boost your returns dramatically, but it can also lead to some very steep losses.
Using our same example in the preceding section of purchasing 10 shares worth $100 each, imagine that, instead of the share price increasing to $125 in a year, the price drops to $75, meaning the value of your shares is now $750.
Assuming you purchased the shares using cash, your loss on capital would be -25%.
With margin trading, remember that you still need to repay the principal ($500) as well as the accrued interest ($40), leaving you with just $210. In this scenario, your loss on capital would be -58%.
If margin trading can lead to theoretically infinite returns, then the opposite is also true: it can lead to infinite losses. The more leverage you use, the greater the potential losses will be.
Although brokerages may place a limit on how much leverage an investor can use, thereby limiting their returns, it also limits their potential losses, serving to protect investors as well.
Managing the Risks of Margin Trading
If margin trading has the potential to be so dangerous, then does that mean investors are better off staying away from it entirely?
No matter what you do in investing, there will always be some element of risk involved – that’s something that cannot be avoided, no matter how hard an investor tries. However, most investors don’t let this stop them from pursuing their goals because they know that the key to success lies in having a strong risk management framework in place.
Margin trading is no different: the key to making the most of its potential advantages while preventing the risks from materializing is to keep risk on a tight leash.
One simple way to do this is to limit how much leverage you plan to use. Perhaps you impose a 10% leverage limit and adjust this based on the types of investments you decide to pursue and your current level of comfort/skill.
Perhaps you use leverage for very specific purposes only, such as buying property for real estate investment purposes. For example, unless you happen to have millions of dollars in the bank it’s very difficult to buy an apartment complex or house entirely with cash; chances are you’ll need to take a mortgage to make these big purchases possible.
Margin trading isn’t some inherently evil thing that investors should avoid, after all, many investors have successfully used it before without letting the risks blow up in their faces. The key to their success lies in having strong risk management processes and procedures in place, as well as having the temperament needed to stay cool when emotions start to run high.
Weighing the Pros and Cons Before Proceeding
Like any other major investment decision, it’s important to weigh the pros and cons accordingly before deciding to proceed. Naturally, margin trading isn’t exempt from this.
Some investors hyper-fixate on the possibility of outsized returns via margin trading, yet overlook the fact that things can turn very ugly if the risks materialize. Conversely, some investors focus too much on the possible dangers of margin trading, yet fail to consider its potential benefits.
This ultimately boils down to being a judgement call, but it would be wise for an investor to take their experience, knowledge, and level of investment intuition into account before making the decision to take part in margin trading or not.
Wrapping Up
Many investors are always looking for new ways to improve their returns, and fortunately, there are many ways to achieve this. One of these methods is margin trading.
The power of margin trading lies in the idea that you can commit less of your own capital for investment purposes while achieving potentially higher returns. This is accomplished by using leverage (i.e., borrowed money).
While potentially higher returns are possible through margin trading, potentially steeper losses are also a possibility. To help prevent this, limits are usually imposed on investors as to how much leverage they can use when performing any sort of margin trades or debt financing.
Although margin trading is certainly a double-edged sword, the key to preventing it from engulfing you is to have a proper risk management system in place. Whether it’s limiting how much leverage you use based on the types of investments you pursue or using leverage under specific circumstances, don’t let the potential risks of margin trading prevent you from reaping its potential benefits.
