You may find margin useful when you want a short-term bridging loan. Other than that, however, we advise against using margin—especially given the market’s volatility.
Stock prices rose after the US cut corporate taxes. This led some investors to buy shares on margin (money borrowed from their brokers). But now stock prices have stalled.
Buying stocks on margin can make sense when you want a short-term loan—provided that you can pay off the loan quickly. That is, margin can give you the financial flexibility to take advantage of opportunities while you’re temporarily short of cash.
Say your employer will pay you a bonus in three months’ time. And say you want to buy Canopy Growth ahead of the government’s legalization of recreational marijuana use. There are risks. Will Canopy sell as much as it wants to? How much revenue will governments take? What happens if a surgeon botches an operation while stoned? Will smuggling lead to more detailed searches when Canadians cross the border? If you can accept the uncertainties and you need no dividends, you might buy Canopy Growth on margin and quickly pay off the loan.
Pot stocks expose you to uncertainties
Your broker can lend you up to half of the market value of most stocks. In fact, if these stocks serve as the basis of options (what’s known as ‘option-eligible stocks’) your broker can lend you up to 70 per cent of their market value.
Here’s an example of how investors can use margin to try to take advantage of the leverage. Let’s say you buy 100 shares of Smith Falls, Ontario-based Canopy Growth Corp. (TSX—WEED). If you buy a board lot outright for $3,943 and Canopy Growth goes up a dollar, you would earn 2.5 per cent. By contrast, if you put down only 50 per cent, then a rise of a dollar a share will double your gain to five per cent.
In most cases, however, we advise against buying stocks on margin. Leverage can also work in reverse—and lead to unforeseen mistakes.
Margin can force you to make the mistake of selling low what you previously bought high. In the event of a sharp share price setback, your broker may call and tell you that you have to put up more margin. If you cannot come up with this cash, the broker will sell your position. That is, you’ll have to sell Canopy Growth at the wrong time—just as your stock becomes cheaper. This is the time that you should buy this stock.
Margin can also lead to a short-term focus. When you make long-term investments you have a high probability of success. But in the short-term, it’s very difficult to know which way a stock will move. After all, studies show that market timing usually fails. Yet when you buy stocks on margin, you need one that’s going to move today. Otherwise, you’ll lose money due to the interest that compounds monthly on your margin loan. We think that the short-term focus margin brings with it is apt to backfire and may lead you to buy what you shouldn’t.
Whether you use margin for a short-term loan or to speculate, make sure to leave a buffer. That is, make sure that you remain well below the 50 or 70 per cent limit. That way, your broker will not need to make a margin call—or sell your stocks—even if the market values of your stocks temporarily drop.
HELOCs will never get a margin call
For reasons outlined above, margin is best used as a short-term bridging loan. That is, to let you take advantage of an opportunity when you can quickly pay off the loan.
In most other cases, we advise against buying stocks on margin. Besides, if you must use leverage, there are better ways to borrow.
One alternative is to take out a small HELOC (Home Equity Line of Credit) and invest the cash. The interest you pay on the line of credit is tax deductible, just like the interest that you pay on margin money.
One advantage of this method is that you’ll never get a margin call. If your stocks fall, you need not put up more money. The bank will not force you to sell your stocks. Even if your stocks become worthless, the bank will let you be as long as you service your HELOC.
This is an edited version of an article that was originally published for subscribers in the July 6, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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