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We've had a nice run in the markets since last month, but we've only got a few more weeks of the bulls.
And that means one thing…
Right now is the perfect opportunity to increase the size of your portfolio… while "using other people's" money to double what you've made in the past three months.
There's an easy strategy you can use to double your money and your profit potential that billionaire investors, like Carl Icahn, are using.
But it's not an approach I would normally suggest…
How to Buy on Margin to Double Your Money
As the old saying goes, "it takes money to make money."
This may be true, but it doesn't necessarily have to be YOUR money.
There's a way you can borrow money from your broker in order to buy stocks – called "margin" (or "buying on margin").
Buying a stock on margin is basically borrowing from your broker. You can borrow up to 50% of the required capital to purchase the amount of shares of stock you want. But always remember that you don't have to go up to the full 50% if you don't want to.
The amount of money you spend to buy stock on margin is called your "initial margin." In order to set up your account for margin, you have to at least have $2,000 in your account. This amount is called your "minimum margin."
Some brokers may require more, so you'll need to check with yours if you decide to do this. Keep in mind that your broker is required by law to get your signature of agreement before setting up your margin account.
Another component of buying on margin is called "maintenance margin." This is the minimum account balance that must be maintained. If you don't maintain this balance and fall below it, you will suffer from what's called a "margin call." This means that your broker will "call" you to require more cash to bring your account back to, or above, the maintenance amount.
If you do not have the cash and are unable to bring in the amount of money needed, your broker can – and will likely – sell the securities in your account to meet this minimum required amount.
The initial and maintenance margin amounts are set by the Federal Reserve Board and your broker.
Increase Your Buying Power on Margin
Let's say you add $10,000 to your account, and it is signed and approved to be set up as your margin account. You now have "buying power" of up to $20,000.
"Buying power" is the amount of money you have available to buy securities. In a margin account, it's the total cash held in the brokerage account as well as the maximum margin amount that's available to use.
In this case… you put up 50% of the purchase amount of stock, which means your broker can allow up to another $10,000 for you to use.
Now let's say you decide to buy $8,000 worth of stock out of that $20,000. You're left with $12,000 in buying power. You don't start tapping into your margin amount until you reach the purchase of $10,000 or more of securities.
Keep in mind the buying power of your account changes daily due to the price movement of the marginable securities in your account, which brings up another point…
Not all stocks can be purchased on margin. Brokers most likely will not allow penny stocks or IPO (initial public offering) stocks to be purchased on margin. However, the Federal Reserve Board makes the decision as to which stocks can be bought on margin.
Now earlier, I mentioned that buying on margin is not an approach I normally suggest, and this is because there are risks involved.
Since great traders analyze risk first, let's take a look at the risk involved with buying on margin…
You Can Get a Margin Call if the Security Performs Poorly
Here's a scenario to better show you what happens when you get a margin call.
Say you have a margin account that allows up to 50% margin and a maintenance amount of 30%.
You buy $20,000 worth of stock. You put up $10,000 toward it, and your broker adds $10,000 to your account.
The stock drops to where the value of the position is $15,000. This would come out of your cash first… so with the position falling to $15,000, your account's equity drops to $5,000 (the $10,000 you put up minus the $5,000 drop in price).
In addition, the maintenance requirement is 30%, which means you have to maintain $4,500 in cash value. At the moment, you're okay because you're at $5,000… but you're getting close to falling below the minimum required amount.
But what if the maintenance margin requirement was 40%…?
In that scenario, your account would need to have an equity value of $6,000 (40% of $15,000 = $6,000). But the value of the equity in your account is only at $5,000 – which means you're now at risk of getting a margin call.
Also, remember that buying on margin is like taking a loan. And with loans come interest. A margin call is the same. If you get a margin call, you will need to pay interest. Now it may only be a small amount to pay, but you're still in the position of having to pay interest on a losing position (or depreciating asset)… and that's not something you'd likely want to endure.
One other thing…
You may need to liquidate your position in order to cover the margin call. So you would have basically taken a loan from your broker to buy stock… which then dropped to the point of your account getting a margin call… resulting in your liquidating the position in order to pay the loan plus interest back. And all while waiting and hoping for the stock to come back to you. And in this scenario, it's quite possible that it never does…
In this case, the prospect of doubling your return on investment (ROI) by "using other people's money" may look intriguing.
But I seriously caution you – especially if you're a newer trader – about the risks we discussed above. Remember, it is possible to lose more money than you originally shelled out.
With that said, here's the upside to buying on margin…
Double Your Shares… Double Your Profit
Instead of spending your own money to buy twice as many shares of stocks, you can have your broker pay for the shares – which increases your buying power. Increased buying power means you have the choice to buy twice as many shares as you might have otherwise been able to (in some cases).
And when you have twice as many shares, you have opportunity to make twice as much money as you otherwise would.
Let's take a look at another scenario…
Say you want to buy 1,000 shares of a $20 stock. You would need to pay $20,000.
But on margin, you can pay up to just 50% ($10,000) while your broker fronts the other 50% ($10,000) on margin. The broker also has a maintenance margin of 20% (or $4,000).
If the stock drops below the maintenance margin amount, then a margin call will likely be issued.
Let's say the company beats its projected earnings and revenue estimates, causing the stock to jump and your position to hit $25,000. If you decide to sell the full position, then your broker gets that $10,000 back.
The rest of the remaining money (or $15,000) is the original $10,000 that you put in… leaving you with a profit of $5,000. Your ROI here is 50% (the $5,000 profit divided by your $10,000 original capital).
Now this may not seem like a lot, but compare this to your fronting the full $20,000 yourself. Had you done that, your ROI would only be 25% (the $5,000 profit divided by the $20,000 you spent). That's still not a bad return, but you doubled your ROI in this example by using margin.
You Can't Buy Options on Margin, However…
Options aren't considered marginable; therefore, they can't be bought on margin. Now there is the covered call strategy, where you'd buy the stock and sell calls against it… and I guess you can consider buying the stock on margin for that…
But if the brokerage has to liquidate the stock in order to cover the margin call, that could present a huge problem for you.
Now if you did opt to do this, I would hope that the open sold calls would be closed against the stock so that your account wouldn't end up in a naked call position (where you don't actually own the underlying stock on the options you bought). And in that scenario, you may not have the clearance to participate in the one of the riskiest trade scenarios… if not the riskiest of them all.
I don't think a broker would let that happen to you… but that's another example of why I'd never recommend naked options (calls or puts). To me, the risks outweigh any potential advantages. But if you insist on trying this method, make sure you familiarize yourself with all rules and regulations – and everything else you can. Also, always make sure you discuss the risks and advantages with your broker.
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About the Author
Tom Gentile is widely known as America's #1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Now, he's diving into the biggest market in the world - one that almost no one has heard of before.