Buying a security using amargin accountmeans you are borrowing money so you can buy more shares thanyou have cash for. This is risky, because if your investment goes down, you have lost not only your moneybut the money you borrowed. Let's look at why this won't work for mutual funds, while looking at other ways you can buy other types of funds on margin.
The Difference Between Stocks and Mutual Funds
Because of the pricing/trading mechanisms used with mutual funds, they cannot be bought and sold like stocks. When trading stocks, an investor can place limit orders, engage in short selling, buy on margin, and make trades in the secondary market throughout the day.
Mutual fund shares, on the other hand, are issued to buyers and redeemed from sellers directly by the fund company. Fund share prices are determined once a day after the close of business and are based on the closing prices of the underlying securities in the fund's portfolio. Fund share buy-and-sell prices are not posted until the day after the transactions occur. This makes it difficult to get out of a mutual fund quickly when it is losing money. For this reason, you cannot buy mutual fund shares using a margin account.
Using a Margin Account for ETFs
Because of these limitations with conventional mutual funds, exchange-traded fund, which are index mutual funds structured and listed as stocks, were originally created in response to professional traders' desire to trade funds with the same facility as stocks.
You can buy ETFson margin. It is important to understand the risks. If you borrow money to buy an ETF and it drops in value, you will have to make a deposit in your margin account. In addition, you will pay interest on the money you borrowed. Either of these situations can be fatal to your investment.And even if you don't lose the entire investment, the costs eat into your profits from your ETF.
Then there is the double threat:Some ETFsuse margin to buy the securities they hold. When you see an ETF that attempts to achieve twice or three times the rise from its underlying index, that means the fund is using leverage, or borrowed money, to attempt to achievethose results.Then, if you borrow money to buy that leveraged ETF, you have even more risk. Also, brokers will not let you borrow as much money to buy this type of ETF. The potential losses are enormous. For example, anETF that seeks twice the performance of an index can lose twice as much when the index drops. If you have borrowed money to buy that fund, you are losing money faster, too. You could lose as much as three or four times the money in a single drop.
How You Can Use Margin to Profit From a Mutual Fund
If you really want to use leverage in a mutual fund, buy a mutual fund that uses leverage itself. The fund can borrow up to 33.33% of its portfolio value to buy more securities. The fund takes on the borrowing expense. Note, however, that you can still lose money fast if the fund has guessed wrong. You won't have to deposit money in a margin account to make up for the loss, but you do end up paying for the loss when the mutual fund net asset value (NAV) goes down as a result of the loss.
The Bottom Line
Investing on margin is a sophisticated, risky maneuverthat can burn even experienced investors. If you want to get in on the world of investing on margin, educate yourself. Better yet, work with an advisor who can steer you through the pitfalls.
FAQs
This makes it difficult to get out of a mutual fund quickly when it is losing money. For this reason, you cannot buy mutual fund shares using a margin account.
Can you purchase mutual funds on margin? ›
While mutual funds cannot be purchased on margin, they can be used as collateral for margin purchases of other securities in some cases. Requirements vary between brokerage firms, but generally, the fund must be held for 30 days to be used as collateral for margin.
What cannot be bought on margin? ›
Non-marginable securities include recent IPOs, penny stocks, and over-the-counter bulletin board stocks. The downside of marginable securities is that they can lead to margin calls, which in turn cause the liquidation of securities and financial loss.
Can you buy a stock with only margin? ›
Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be able to normally. To trade on margin, you need a margin account.
Can you only short with a margin account? ›
The reason margin accounts (and only margin accounts) can be used to short sell stocks has to do with Regulation T—a rule instituted by the Federal Reserve Board. The reason you need to open a margin account to short sell stocks is that the practice of shorting is basically selling something you do not own.
What is the 30 day rule for mutual funds? ›
A roundtrip is a mutual fund purchase or exchange purchase followed by a sell or exchange sell within 30 calendar days in the same fund and account. For example, if you purchased a fund on May 1, selling the fund prior to May 31 would incur a roundtrip violation.
Can you take cash out of a margin account? ›
For example, you are usually limited to withdrawing the cash value of your margin account, usually up to 50% of the value of the securities in your account.
What is the big problem with buying on the margin? ›
The biggest risk from buying on margin is that you can lose much more money than you initially invested. A decline of 50 percent or more from stocks that were half-funded using borrowed funds, equates to a loss of 100 percent or more in your portfolio, plus interest and commissions.
Why is buying on margin illegal? ›
Buying on margins of 10 percent cash was made illegal because the practice contributed to the crash of the stock market in October of 1929. In the mid to late 1920's, the economy was booming and the country was benefiting from the success of the industrial revolution.
Can closed-end mutual funds be bought on margin? ›
Because closed-end funds are traded in the secondary market, they can be purchased on margin (with borrowed money) and sold short.
The opportunity to leverage assets
This enables you to potentially magnify your returns, assuming the value of your investment rises. Federal Reserve Board Regulation T allows investors to use margin to borrow up to 50% of the value of a securities purchase.
What triggers a margin call? ›
There are three ways to receive a margin call: You trade for more than the buying power in your account. The value of your margin account decreases. Your broker raises the house maintenance margin requirements.
Are margin accounts a good idea? ›
The Dangers of a Margin Account
While a margin account can amplify your gains, it can also magnify your losses. Having to liquidate stocks during a margin call, because market losses have reduced the value of your investments, makes it very challenging to invest for the long term in a margin account.
Can I day trade with a margin account? ›
Day trading, as defined by FINRA's margin rule, refers to a trading strategy where an individual buys and sells (or sells and buys) the same security in a margin account on the same day in an attempt to profit from small movements in the price of the security.
What is the minimum balance for a margin account? ›
To purchase a security on margin, FINRA (a government-authorized regulator of brokerage firms) requires that you have at least $2,000 or 100% of the security's purchase price (whichever value is less) deposited into your account. This is called the margin minimum.
Should a beginner use a margin account? ›
A margin exposes investors to additional risks and is not advisable for beginner investors, and margins can be a useful tool for experienced investors, though if you're new to investing, it might be more prudent to play it safe.
Can both mutual funds and ETFs be purchased on margin? ›
Investments you can hold in a margin account
Stocks (both Canadian and international) ETFs (Exchange Traded Funds) Options. Mutual funds.
Can open ended funds be purchased on margin? ›
Open-ended, equity based mutual funds are eligible for portfolio margin, provided the 30 day holding period as required under Section 11(d)(1) of the Securities Exchange Act of 1934 is satisfied. Money market mutual funds have a margin requirement of 1 percent; other open-ended funds require 15 percent.
Can you buy closed-end funds on margin? ›
Because closed-end funds are traded in the secondary market, they can be purchased on margin (with borrowed money) and sold short. Stocks and bonds can also be purchased on margin and sold short as well, while mutual funds cannot.
Can mutual funds be pledged for margin trading? ›
Yes, you have the flexibility to invest in Mutual Funds and subsequently pledge them for acquiring additional trading margins in the F&O Segment. It's important to note, however, that not all mutual funds qualify for pledge. For the list of Securities and Mutual Funds that are available for the pledge, click here.
