Buying on margin? Tread carefully

When you buy securities on margin, you’re borrowing money from your brokerage at a variable interest rate while using the stocks currently in your portfolio as collateral. It’s risky, because if the market turns against you, you either sell for a loss — plus interest costs — or hold on until the market picks up, paying interest all the while. If you’re borrowing on margin and paying 8 percent interest, you better be pretty confident your stocks will appreciate more than 8 percent, and there’s never any guarantee of that.

When margined securities fall below a certain level, the borrower will receive a “margin call,” requiring an infusion of additional cash. If she can’t raise the cash, the brokerage will sell some of her holdings to generate the needed funds. This can sting, sometimes resulting in short-term capital gains taxed at high rates. Margin can reduce your investing flexibility. If you’ve borrowed moolah to invest in a stock and it falls sharply, you may end up forced to sell when you’d rather wait it out.

Margin amplifies your investment performance. As an example, imagine that you hold $100,000 of stocks and you margin that to the max, borrowing $100,000 to invest in additional stock. If your holdings double in value, you’ll have earned an extra $100,000 (less interest expense) thanks to margin. But if your $200,000 holdings drop by 50 percent, they’ll be worth $100,000 and you’ll still owe $100,000 (plus interest). That will leave you with … nothing. Your holdings dropped by 50 percent, but margin amplified that to a total loss. Margin cuts both ways.

Only experienced investors should use margin, and many steer clear of it. It’s smart to limit yourself to borrowing no more than around 20 percent of your portfolio’s worth, if you borrow on margin at all. On The Motley Fool’s discussion boards ( www.fool.com), one of the most read and recommended posts was written by a reader from Missouri. It detailed how he lost his entire portfolio, $60,000, in two weeks — by investing on margin.

Be careful out there, investors.

Ask the Fool

Q: What’s a stock option’s “strike price”? — G.H., Elyria, Ohio

A: Imagine that you work for International Alphabet Corp. You’re issued 1,000 employee stock options with a strike (or “exercise”) price of $10 each. A few years later, International Alphabet goes public, issuing shares of stock for the first time via an initial public offering (IPO). The shares (trading under the ticker symbol ABCDE) are initially priced at $20 each, but a year later they’re trading at $35. At this point, you decide to “exercise” your options.

Because your options carry a strike price of $10, you’re entitled to buy up to 1,000 shares at $10 each — not the $35 that they’re going for on the open market. If you exercise all of them, you’ll fork over $10,000 for 1,000 shares to your company, and they’ll immediately be worth $35,000. You can hang on to them as long as you like, or quickly cash out for a $25,000 profit.

As you might suspect, it’s not exactly quite this simple. There are many tax issues to consider, and your option plan might have some special features. Read the plan carefully. You might also read “Consider Your Options” by Kaye Thomas (Fairmark Press, $24).

Q: How are stockbrokers paid? — N.V., Beaumont, Texas

A: They’re generally paid by salary, commissions on sales, or a mix of both. It depends on the brokerage they work for. Many brokers depend heavily on commissions, which can lead them to actively and needlessly generate trades in your account. That’s called “churning.” We’d rather see brokers paid flat salaries, with bonuses for results that outperform the market averages. Learn more about brokers and brokerages at www.sec.gov/investor/brokers.htm and www.broker.fool.com.

My smartest investment

I don’t know if I can really call it a smart investment when I bought shares of eBay at $10 apiece back in 2001 because at the time I bought more on a “Hey, I know that company!” instinct than real valuation. I’m glad I sold it at $55 in January. That I think I can honestly claim as being smart. Whether buying in again recently at $32 per share was particularly smart … we’ll just have to wait and see. Overall, though, the absolute smartest investment I’ve made has been in myself. Not only am I getting returns comfortably above the major indexes, but I’m getting an intense personal satisfaction from being able to say, “Hey, I done good.” That feeling alone is worth every word I’ve read, every dumb question I’ve used to expose my idiocy, every hour spent going over it again and again until I got it, every minute spent running a prospective stock through my MakesSenseOMeter(TM). — Tamarian Graffham, Tracy, Calif.

The Fool Responds: Investing in yourself tends to pay off well. Kudos!