Lower-Cost Alternatives to Margin (Part 1)
02/09/2009 1:20 pm EST
Aggressive investors will often use margin to increase their buying power and leverage, however, margin has significant downside risks as well. With recent product innovations, traders may want to use margin less and less. In this article and the accompanying video, we will look at what margin is and why some of the new products in the market may be better alternatives.
Margin increases your buying power. By using margin, it is possible to borrow half the cost of a stock from your broker. For example, if a stock costs $20, but you borrow half of that amount from your broker, you have only invested $10 of your own money.
Because you have used margin, if the stock moves to $25, you have made a 50% return on your investment. If you had financed the entire purchase from the cash in your account, you would have only made 25%. Margin can also be used by option traders to finance half the price of a long option contract. The potential benefits are similar to buying stock on margin, but the risks are also the same.
Two of the most significant disadvantages of using margin are costs and increased risk. The amount of money you borrow from your broker has interest charges attached to it. I surveyed a few brokers today and saw margin rates that averaged approximately 6.5%. If that margin "loan" is held for a long period, the interest charges can really eat into your profits. The increased risk of margin is the same as with all kinds of leverage. The increased buying power means that you could lose a larger percentage of your account if trades go against you compared to just using cash.
Click here to find out how margin works for forex traders.
More traders are beginning to turn toward leveraged ETFs as an alternative to margin. These products trade like stocks or standard ETFs, but replicate the performance of using margin. This provides the benefits of margin without all the costs. The fees in these kinds of funds are higher than traditional ETFs, but they are much lower than the interest due in a margin account. In the video below, I will contrast investing in a leveraged ETF that replicates the S&P 500 index with trading the SPY on margin.
There are other advantages to leveraged ETFs that we will take a look at in subsequent articles in this series.