Pros and Cons of Margin Trading

How does borrowing money to potentially increase your profit sound? Of course, you have to pay it back, plus some, but that will be fine if you pick the right company's stock. This is the idea behind buying on margin. If you are an experienced investor who knows the intricacies of making money from the stock market, you may see taking the loan as a potential short-term investment strategy. If you are not a financial risk-taker, you may see it as gutsy move you cannot afford to make.

Buying on margin According to the U.S. Securities and Exchange Commission, investors can buy on margin, or borrow money from a broker to purchase more stock than they would be able to if they were to pay the full amount with cash. If your stock is successful, you will have no problem paying back the loan, and the interest and commission that came along with it, and still consider your investment a success. However, buying on margin is risky, and investing in a company's stock that turns out to be a dud can cost you big time.

Pros Buying on margin increases your purchasing power, which can lead to greater profit. If you understand how the process works and know the risks, you may reap the rewards.

"[When you buy on margin,] you are able to maximize your exposure and magnify your returns when your investments pan out in your favor," says Brian Ullmann, a wealth manager with Fresno, Calif.-based Ford Financial Group. "For example, someone with a very small amount of money invested, such as a young worker [or] investor, can have more money in the stock market and dramatically increase returns." Cons Alexandra Lebenthal, president and CEO of Lebenthal & Company, says she wouldn't recommend that the average investor buy stocks on margin, noting that there is already a risk built into investing because you don't know for sure if the company is going to do well or even stick around.

"The streets are littered with companies that are no longer with us, even ones that were considered blue chips once upon a time," she says. "Borrowing to invest in a stock exposes you to not only loss of your investment but the need to pay back the loan."

This means buying on margin can lead to greater losses if the stock price drops. You may actually end up losing more money than you invested, thanks to interest payments and commission.

If the price of the stock plummets and the amount of equity in your margin account drops below your firm's required maintenance margin, the brokerage can issue what is called a maintenance or house margin call. This means you have to deposit sufficient funds or securities to get your account back to the correct equity level. If you cannot do this, the brokerage has the right to sell your securities to meet the call without notifying you. You might not be granted an extension, so if you don't get a second chance at bouncing back with that account. Be aware that the brokerage firm can also increase the margin requirements whenever it wants without letting you know.