Buying on margin: leverage for the pros

How high is up? As the bull market ambles along, showing little signs of slowing, it's tempting to get a little extra bang for your buck. Indeed, buying stocks on margin has soared to record levels. But greenhorns beware.

Yes, using margin can transform mere single-digit gains into handsome double-digit profits. But the reverse is also true. If your stock takes a dives or doesn't budge, your margin strategy could put you into a deep hole quickly.

Buying on margin amounts to taking out a loan from your broker to buy more stocks than you could otherwise afford. You borrow against the value of the stocks you own.

To take such a loan, you must have at least $2,000 in stock as collateral. You cannot use margin to buy stocks priced under $5. At present the Federal Reserve Board requires a margin, or down payment, of at least 50 percent of the purchase price. So to buy 100 shares of Fastbuck Inc. at $50, you must put down at least $2,500 in cash. Your broker may lend you the other $2,500.

After the 1929 crash, the Federal Reserve Board was given the power to regulate how large or small the margin down payment would be. Before the crash, people could buy stocks with little or no money down, and this led to rampant speculation. Traders reasoned: Why not gamble on a stock if it didn't cost much initially? Since the Fed took over in 1934, margin requirements have fluctuated between 40 percent and 100 percent (no buying on margin allowed).

Without margin, a typical investment might go like this: You have $2,500 to invest and you decide to buy Fastbuck Inc. at $50 a share. You can afford 50 shares. If Fastbuck goes up to $60, then your profit (before commission fees) is $10 per share, or $500.

By using margin, you can double your profits: Take your $2,500 and then borrow another $2,500 from your broker. You can now buy 100 shares instead of 50. If Fastbuck Inc. rises to $60, then your gain is $10 per share, but on twice as many shares. Your profit: $1,000 instead of $500. Also, while you own the stock, you collect dividend payments on 100 shares instead of 50.

But the doubling effect works both ways. If the price of Fastbuck tumbles, your losses mount faster. Michael Driskill, a Merrill Lynch broker, says: ``You have to be pretty judicious in how you use margin. I give my clients the best- and worst-case scenarios before entering a margin position.'' Not all brokers do this, but they should.

If the price falls too far, you will get a ``margin call.'' That's a call from your broker to send more money or securities to cover a drop in the value of the stock you used as a down payment.

How far can the stock fall before you must ante up? Although the Federal Reserve Board sets the intial down-payment size, the ``margin maintenance'' level is set by each brokerage. Actually, the exchange or association that your brokerage house is a member of sets the minimum. The New York Stock Exchange puts the margin minimum at 25 percent. Most brokerages, though, want you to keep the value of your collateral at 30 percent.

Take the earlier example of a margin purchase of $5,000 worth of Fastbuck Inc. (100 shares at $50). You and your broker each put up $2,500. Suppose Fastbuck Inc. loses a huge consumer liability lawsuit and the stock falls to $35 a share. The value of your holdings slumps to $3,500. Have you fallen below the 30 percent margin?

One way to figure this: If you sold your stock now and paid your broker back the $2,500 loan, you would have $1,000 left over. And $1,000 is 28.6 percent of $3,500 (the current market value of your holdings). So your broker will call you to ask for more money to bring the margin above 30 percent. If you don't have the money, he'll sell the stock. And you'll be at least $1,500 poorer for buying on margin, whereas, if you hadn't used margin, your loss would have been limited to $750.

``We suggest that investors don't use margin unless they're very experienced,'' says Thomas E. O'Hara, chairman of the National Association of Investors Corporation. He notes that margin buying tends to be for more risk-oriented traders and not long-term ``buy-and-hold'' investors.

Indeed, the costs involved in margin trading mitigate against long-term positions. The broker's loan isn't free. Generally, it's at a better rate than what you'd get on a consumer bank loan. Currently, that means paying 10 to 12 percent on a margin loan. By the way, those loans generate a tidy sum for brokerage firms.

There's another cost (and benefit to your broker) a margin user should be aware of. You double your commission fees when you trade a fully margined stock. That is, you pay for trading 100 shares of Fastbuck Inc., even though you only chipped in enough money to buy 50 shares.

If you decide to use margin, remember that it's primarily for ``more-aggressive or speculative investors,'' says Mr. Driskill at Merrill Lynch. He says he's been successful using it selectively -- only on fundamentally sound stocks that he's watched long enough to think they've fallen into the low end of a well-proven trading range.

As a safeguard against a precipitous drop in the stock, investors should decide early how much money they're willing to lose. Then, place a ``good-until-canceled'' sell order with your broker. You don't have to go to the 30 percent limit before selling.

``When I use margin, and the strategy isn't working, we only take a 10 or 15 percent loss before getting out,'' Driskill says. ``I always go into the position with that understanding.''