Personal Investor: Stakes are high for margin investors
Some investors make it a rule to never invest more than they can lose. They will probably never have a margin account.
A margin account is set up through a broker to lend money to an investor. It’s a way to supercharge your returns, but investors who borrow to invest should understand the risk of losing more than their initial investment, plus the interest accumulated on the amount you lose.
Here’s how it works: The broker can lend up to 50 per cent of the purchase price of securities such as stocks and bonds. The amount is based on the price at the time of purchase. If it goes up, the amount of the loan can be increased.
The interest rate depends on the lender, but customers with a long record of investing and plenty of money might get a break.
The securities are used as collateral for the loan, so the lender is covered as long as the stock doesn’t fall below the original purchase price. If that happens, the lender will usually make what is termed a “margin call”, demanding enough cash to keep the loan at 50 per cent of the value of the securities. The investor might have to sell the security at the lower price to cover the loan, dip into their own cash reserves, raise the cash, or put up other securities as collateral. The lender really doesn’t care as long as the loan is covered.
The risk level rises several notches for investors shorting securities. They are allowed to borrow 50 per cent of the value of securities that they are borrowing in the first place. They could get a margin call if the stock rises – and there’s no limit to how high a stock can rise.