TORONTO - Buying securities on margin is another name for investing with borrowed money and like so many things involved in investing, it has its pros and cons.
"The leverage is wonderful but it can be very, very harmful and therefore you have to be careful of what you buy, you have to be prepared for watching it all the time," said Bob Tebbutt, vice president, risk management at Peregrine Financial Group Canada.
"So it's not for every investor."
Buying on margin means that you borrow money from your broker to buy stocks and the amount you can borrow is based on how much you have in your account.
This is debt after all and your margin account would have to be approved by the brokerage.
Once that is done, you could for example, buy $100,000 of stock but only using $50,000 of your own money. There is no fixed interest rate - but it is based on banks' prime rate and depending on your credit worthiness, you'll pay a point or more above prime.
So now you have $100,000 worth of stock.
If all goes well and the stock goes up 10 per cent, that means the value of your account is up 20 per cent.
Trouble is, if you have guessed wrong, a ten per cent move down means your account is short 20 per cent.
If that happens, you will find the brokerage won't be offering sweetheart deals like no payments until 2011 - the firm will want you to settle up immediately.
And if you are financially embarrassed for the amount, the brokerage has the right to sell other securities in the account to settle the debt.
Tebbutt thinks the number one condition for the would-be margin user is be prepared to lose money.
"What it really gets down to is what kind of psychology do you have, what kind of inner strength do you have," he said.
Discipline is also essential, both in picking the right stock and the amount of margin you want to use.
"The problem with margin is that you have the availability of it," said Paul Harris at Avenue Investment Management.
"If you want to margin 10 or 15 per cent of your overall portfolio, that's probably not a bad thing."
But then, he observes, people have a problem with disciplining themselves.
"People margin too much - as a general rule, that's what gets them hurt. And the other thing they do that's really bad is that they always sell. But they never sell the stock they're margining against. They always sell something else to create the liquidity."
Harris said another problem is that people tend to margin the wrong stocks.
"They seem to margin to buy some small company because they want to own a lot of the position or they feel it's going to go up," he said.
That's why he advises you to use your own money for riskier plays and use margin for the safest stocks possible, blue chip stocks like the TD Bank. (TSX:TD).
"What happens is they don't margin against TD, they margin against some small company and then the stock falls below a dollar (an amount not covered by margin) and then you get the margin call."
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