Investment Strategies

Buying on margin means borrowing money from your brokerage firm to purchase securities, using your existing holdings as collateral. It can magnify gains, but it magnifies losses just as much, and it can force you to sell at the worst possible time.

How it works

You open a margin account and agree to terms with your broker. Federal rules require you to put up a minimum percentage of the purchase price yourself, and your firm may require more. The broker lends the rest and charges interest on the loan, which accumulates as long as the balance is outstanding.

A simple example

Suppose you buy investments with half your own money and half borrowed. If the investments rise, your percentage gain on your own money is larger than it would have been without the loan. If they fall by the same amount, your percentage loss is larger too, and you still owe the loan plus interest. You can lose more than you originally invested.

Margin calls

Brokers require that the equity in your account stay above a maintenance level. If your holdings fall in value and your equity drops below it, you receive a margin call and must deposit cash or securities. If you cannot, the firm can sell your holdings without asking you, and it may choose which ones. Firms can also raise their requirements with little notice.

Risks to understand

• Losses can exceed your initial investment.
• You may be forced to sell at a low price and lock in the loss.
• Interest costs reduce returns and add up when positions are held for long periods.
• Volatile or concentrated holdings make margin calls more likely.
• Margin agreements generally allow the broker to lend your securities to others.

Tax points

Interest on money borrowed to buy taxable investments may be deductible as investment interest, but only up to your net investment income, and only if you itemize. Interest used to buy tax-exempt bonds is not deductible. The IRS discusses this in Publication 550 at irs.gov.

If you use margin anyway

1. Borrow far less than the maximum available.
2. Keep cash on hand to meet a call.
3. Read the margin agreement carefully, including interest rates and your broker's right to sell.
4. Avoid margin for speculative or illiquid investments.
5. Have a plan for how and when you will repay the loan.

The SEC's investor education site, investor.gov, has helpful margin guidance. For a discussion of how borrowing fits your overall plan and tax situation, contact our office.