By investing on margin, you can grow your portfolio faster. But this path is fraught with risks for investors without a game plan.
Many investors have lost everything they invested (and quite a bit more) by ruthlessly using the margin. And the strategy has rightly earned a reputation for being dangerous.
However, it is possible to take advantage of leverage and not get burned financially. Let’s examine how you can safely use leverage.
Investing on margin, explained
Before we can dive into the details of smart investment strategies that use leverage, let’s break down how the strategy works. Essentially, a margin investment means using money borrowed from your investment broker to buy investments.
Before you can begin, you will need to apply for a margin account with your broker and be approved. Once the margin account is set up, you can use the cash and securities in your regular account as collateral to borrow more money.
The point of margin investing is to capitalize on potentially high returns. If you expect a particular stock to go up, you can use borrowed funds to buy more stocks than you otherwise could. To make a profit, the investment must generate a higher rate of return than the interest on the loan.
With the ability to borrow more money than you have available, a margin investment is an opportunity to increase your profits. However, this strategy can quickly go south as it also exacerbates losses.
For example, let’s say you invest $ 5,000 in ABC stocks using $ 2,500 in cash and $ 2,500 in margin. If the stock appreciates 20% to $ 6,000, you are actually making 40% of your $ 2,500 investment. But if stocks fall 20% to $ 4,000, you’ll lose 40%.
How to use the lever without getting burned
Now that you know a little more about margin investing, it is clear that it is riskier than investing with cash. However, that doesn’t mean it’s always a bad idea. In fact, it gives you the opportunity to grow your portfolio faster. Let’s examine some of the strategies you can implement to prevent burns.
Understand your tolerance for risk
Investing on margin is not a good choice for everyone. A successful investor who leverages margins is likely to have a high tolerance for risk and a willingness to closely monitor their investments.
Unless you have a high tolerance for risk, the potential downsides of investing on margin could be too big for you. And that’s fine! Don’t dive into margin investing if you are uncomfortable with the idea of potentially increasing your losses.
With a higher tolerance for risk, you will be better able to take the risks associated with margin investing. This level of comfort can help you stick to your investment strategy during the inevitable ups and downs.
Not sure where your risk tolerance level stands? Check out these reviews to find out.
First, learn the ropes of investing
Building an investment portfolio is an exciting prospect. When it comes to delving into this new world of money for the first time, take things slowly. I wouldn’t recommend investing in margins until you have a solid understanding of how the market works.
Without a clear understanding of the market, it is very easy to lose money on margin investing. Need some help learning to invest in stocks? We’ll cover you. Read our guide here >>>
Limit your leverage
If you’re looking for higher returns, it can be tempting to go all in. After all, you believe that a particular stock will go up and bring you huge profits. However, you should avoid overwhelming yourself. Instead of using as much leverage as possible, set a percentage of your portfolio that you are comfortable with and stick with it.
It is up to you to decide where to limit your leverage. Many feel good between 10 and 25%. With a cap on your leveraged odds, you limit the damage that can be done to your portfolio if a trade is against you.
Use the margin sparingly
As I mentioned above, it’s good to keep an eye on a cap when using leverage. But you should probably go a step further and avoid investing in margin too often.
When margin trading becomes a regular habit, it can be difficult to stay engaged and alert while monitoring your positions. Instead, only use margins when you find a worthwhile opportunity. As a result, you will be more disciplined throughout this investment cycle. So you can keep everything on track to the best of your knowledge.
If you are unable to muster the time and energy required to effectively monitor your leveraged investments, you might want to hold back.
Put stop-loss orders
One way to limit your margin investing risk is to place a stop-loss order right after entering a position. This allows you to automatically exit a position if the stock falls to a level you set – even if you are not monitoring your account at the time.
While stop loss orders are incredibly useful tools, they cannot mitigate the overall risk of margin trading. Stop-loss orders are only executed when the market is open. So, you cannot get you out of position during after-market hours, even if your stock drops well below your desired exit point between regular market sessions.
Don’t forget to consider the margin rate
Even with a lucrative stock opportunity, the interest rate associated with your margin could effectively eliminate potential gains. Some brokers charge lower prices than others, so it can be worth poking around.
However, as a general rule, one of the best ways to minimize your margin interest costs is to maintain a short-term investment attitude. Investments that you want to keep for the long term should be bought with cash.
Final thoughts
Investing on margin is a riskier strategy that is not the way to go for many investors. If you prefer a more hands-on approach to investing. Setting up automatic investments with one of our favorite robo-advisors may be a better option.
However, for experienced and disciplined traders, conservative margin use might be worth considering. If you proceed carefully and take safety precautions like stop-loss orders, you can find that the risk is worth the rewards.
