by Mr. Cheap

Buying on margin is a fairly straightforward, but somewhat dangerous way to buy stocks. Basically the idea is that you buy stock using money that you borrow from your broker. The broker has your stock as collatoral to force you to pay your debt, and will use the value of your account to determine your credit limit.

Usually the interest they charge you on what you borrow is based on how much you have invested and prime (for example, in my E*Trade account right now Im paying prime + 1%, or 7% interest). If you can earn more then this amount through your investment, borrowing is good. If you cant its bad.

Every book and article on investing that mentions buying on margin says how dangerous it is. Basically it magnifies your returns. If you make money, you make more, if you lose money, you lose more (because youve bought more stock and because you have to pay the interest).

If youre buying very volatile stocks, your credit will fluctuate wildly (when the stock is high, your broker will loan you a lot, when the stock is low, he wont). This can lead to a margin call when your debt becomes higher then your limit. At this point, if you cant top up your account to deal with the loses, your broker will sell your stock to cover it. Since the stock is down at this point, you probably wont be happy with the sell decision.

In Canada you can deduct expenses for investment, including interest, which can make trading on margin more attractive. Instead of paying 7%, Im actually paying 7% * (1-marginal tax rate). Say my marginal tax rate was 25%, Im actually only paying 5.25% after I get my tax deduction. With the Bank of Montreal stock I bought recently, Im anticipating a 4% dividend-yield, which should be 3.5% after Ive paid taxes (since dividends are taxed at 1/2 the income rate). Therefore if the long term appreciation of this stock is greater than 1.75% buying it on margin makes sense (which is what I did).

The additional benefit is that I wont always have the opportunity to buy Bank of Montreal stock when its at 4% yield. By the time Ive saved up more money to buy more of the stock, its price may have gone up and it might not be as attractive. By buying on margin, I can buy when the stock is attractive, then use my savings to pay off my broker.

Obviously buying more speculative stocks on margin is far more dangerous than buying blue chips. Additionally, anything I owed to my broker, Id want to feel confident I could pay it off in the near future, whatever happened to the stock.