Use A Margin Account Only For Shorting Stocks
By Larry Potter

Margin-borrowing from your broker--increases your buying power, and when all is right with the world it literally doubles profit potential. But if you make a lousy play you have to pay back double. That's why we have preached for years against using margin. There's already enough risk in the market.

Let's suppose you like stock XYZ at 50 but don't have the cash in your account to buy all that you want. So you decide to "margin" it, which simply means you borrow 50% of the money to buy XYZ from your brokerage. If the trade goes well and XYZ moves higher, you can sell with a very nice profit.

But what if the market is in the process of correcting? Old XYZ could take a 10-15-point loss, and there is a good chance that eventually the brokerage will call you for the balance. Well, if you had to borrow the money to buy XYZ in the first place, where are you going to get the money to pay back the broker? We know that sometimes margin calls go out, and the customer simply doesn't have the money to pay. That is an ugly situation that can result in liquidating positions, closing accounts and facing lawsuits.

It's a different situation with short sales. Brokers insist that you have a margin position to do this sort of trading. That's because short selling involves borrowing shares from your broker before selling them on the open market. When you are ready to close your short position, you "buy back" shares on the open market and return them to the brokerage.

We like to err on the side of safety. Buying on margin might be OK if you are a day trader who has the right tools and is operating in real time and keeping an eye on things. But if you are a short term investor or even a long-termer you have to be extremely careful if you are going to employ margin. You cannot buy something on margin and sit back and forget about it. A bad market stretch can get you into a boatload of trouble.

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