Buying Shares on Margin
Some brokers in New Zealand allow you to buy shares on margin. Buying on margin means that, for every dollar you invest in the market, your broker will lend you more money. The loan is secured on the shares you have bought. You can then use the margin loan to buy more shares.

How Does Buying Shares on Margin Work?
The amount of money you can borrow is dependent on the stocks you buy.

If you buy a large, heavily traded stock, such as Telecom New Zealand (TEL,) the lending ratio will be high at, say, 70%. This means that for every $100 dollars you invest in TEL shares, the broker will allow you to borrow another $70. You can use this borrowed money to buy more TEL shares or shares in other companies.

Lower lending ratios are offered on smaller companies. For example, for every $100 you invest in Turners Auctions (TUA,) you might expect to borrow a further $50.

What are the Advantages of Buying Shares on Margin?
Buying shares on margin enables you to:
  • Buy more shares than you could otherwise afford.
  • Increase the rate at which your profits increase.
What are the Disadvantages of Buying Shares on Margin?
When you buy shares on margin you will need to:
  • Make interest payments on the borrowed funds.
  • Be aware that if the value of your shares falls, then you will lose money faster on margin than if you had no borrowings.
If events are favourable, by how much will margin boost my profits?
Consider the following example in which you have $10,000 invested in TEL. A year after buying the shares, their price has risen 20%. In addition to this capital gain, TEL also pays a dividend worth about 7 percent to standard rate taxpayers.

Without Margin
Profit from rising share price = $2,000
Profit from dividends = $700
Annualised Gain on Starting Funds = 27%

With Margin
You invest $10,000 plus $7,000 borrowed on margin.
Profit from rising share price = $3,400.
Profit from dividends = $1,190
Interest payable on $7,000 margin loan at (say) 10% = $700
Annualised Gain on Starting Funds = 38.9%

If events are unfavourable, by how much will margin worsen my losses?
The example above assumes a 20% rise. What if TEL falls 20%?

Without Margin
Loss from falling share price = $2,000.
Profit from dividends = $700
Annualised Loss on Starting Funds = 13%

With Margin
Loss from falling share price = $3,400.
Profit from dividends = $1,190
Interest payable on $7,000 margin loan at (say) 10% = $700
Annualised Loss on Starting Funds = 29.1%

The Dreaded Margin Call
The lender needs to protect themselves against your shares falling so far in value that they no longer cover the loan. If your shares fall far enough, the broker will make a margin call. In this event, you will need to either put more money into your brokerage account (hoping the prices of your shares will recover) or sell your shares. If you don't take one of these courses of action, the broker will sell your shares and take money as required to cover the loan. Professional share traders say you should never meet a margin call - you should always get out of a trade before this stage has been reached.

The Importance of Not Losing Money
Many of the world's greatest stock investors insist that not losing money is the most vital component of building stock market wealth. Their philosophy is that if you can avoid losses, the profits will take care of themselves. Margin trading magnifies the losses caused when share prices fall and the majority of successful investors advise others - especially beginners - not to buy stocks on margin.

Summary
If you have a high degree of certainty that the stocks you intend buying are going to rise, buying on margin will increase the rate at which your wealth grows. A high degree of certainty rarely exists in the markets, however. Most investors would be better advised to avoid margin accounts.