When is it best to use a margin loan?

You may find margin useful when you want a short-term bridging loan. Other than that, however, we advise against using margin to prevent the problems that margin brings.

Remember that leverage can work both ways when you buy stocks on margin.

As you know, the Canadian stock market has delivered solid gains since the market bottomed in March. This has led optimistic investors to buy more shares on margin (that is, with money borrowed from their brokers).

Your broker can lend you up to half of the market value of stocks that trade at, or above, two dollars a share. 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.

Buying stocks on margin can make sense when you want a short-term loan—provided that you can pay off this loan quickly. That is, margin can give you the financial flexibility to take advantage of opportunities while you’re temporarily short of cash.

Let’s say, for example, that you expect the major oil producers such as Cenovus Energy to acquire companies that operate in Alberta’s oil sands over the next few months. And say your employer will pay you a big bonus in six months’ time. You might buy some of the targets on margin. That way, if the takeovers do occur, you can profit. And once you receive your bonus, you can pay off the margin loan.

Leverage can work for you or against you

Some investors use margin to try to take advantage of the leverage. Let’s say you buy 1,000 shares of Leon’s Furniture for $18,510. If you buy the shares outright and Leon’s rises by a dollar a share, you earn a return of 5.4 per cent on your investment. By contrast, if you put down only 50 per cent, then a rise of $1 a share will double your gain to 10.8 per cent.

In most cases, however, we advise against buying stocks on margin. After all, leverage can also work in reverse, of course.

One problem with margin is that it can force you to buy high and sell low. Let’s say that you buy stocks on margin. In the event of a sharp setback in these stocks, 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 positions. That is, you’ll have to sell at exactly the wrong time—just as your stocks become cheap. This is the time that you would rather buy these stocks.

A second problem with margin is that it tends to lead to a short-term focus. It’s possible to make wise investment decisions that offer you a high probability of success over time. In the short-term, by contrast, it’s extremely difficult to predict which way a stock will move. After all, many studies have shown that market timing doesn’t work. Yet when you buy stocks on margin, you need a stock that’s going to move today. Otherwise, you’ll lose money due to the interest that compounds monthly on your margin. We think that the short-term focus that margin brings with it is apt to backfire.

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 stock—even if the market values of your stocks temporarily drop.

This is an edited version of an article that was originally published for subscribers in the November 6, 2020, 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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