Nitrous oxide ramps up an engine's power by allowing more fuel to be burned. In the stock market, margin works kind of like that.
With margin, you can magnify your returns and buy more stock than you otherwise could.There are advantages and disadvantages to this. And there are times when you should be on margin as well as times when you shouldn't.
Margin lets you buy stock without putting up all of the required capital. Under current regulations, you put up half of the position's value and borrow the other half from your broker.
This 2-to-1 leverage factor is the main reason why investors use margin. If a trade works in your favor, you'll earn a higher return -- more bang for your buck.
Of course, brokerage firms don't lend you money for free. They charge you interest on a monthly basis depending on the debit balance, or how much you borrowed.
Suppose you buy 100 shares of a $100 stock in a regular cash account. You'll need to have at least $10,000, or the full market value of the position, to cover the trade.
If you're right on your trade and the stock rises to $120, your return will be 20% ($2,000/$10,000).
If you make the trade on margin, putting up $5,000 and borrowing the other half of the money from your broker, your gain will be 40% ($2,000/$5000), or twice that of a cash account .
If the stock surges 50% when you're on margin, your percentage return will be 100%, or double your money. That's the power of margin.
However, margin can be a double-edged sword. When you're wrong on a trade, you'll lose money twice as fast.
From the example above, if the stock drops to $80, an investor with a cash account loses 20% (-$2,000, $10,000). But on margin, that's a 40% hit (-$2,000/$5000).
If shares plunge 50%, you will be wiped out (-$5,000/$5,000).
So, should you use margin? In "How to Make Money in Stocks," IBD chairman and founder William J. O'Neil wrote that it's much safer for new investors to buy stocks on a cash basis only.
Investors may consider using margin once they've racked up a few years of market experience. As always, they should trade using a set of sound buy and sell rules.
The best time to be on margin is within the first two years of a new bull market.
When the overall market is acting right and leaders are breaking out of proper bases, that's when the market tends to produce its best opportunities.
You don't have to be fully margined and leave yourself exposed all of the time. Use margin wisely.
It really depends on the current market environment, your risk tolerance and your experience.
The time to get off margin is when a market correction comes on the horizon.
You should sell shares and raise as much cash as possible when distribution days start piling up, or leading stocks start showing topping signals.
Remember: When you're on margin, your stocks fall twice as hard and you'll get hurt twice as bad.