Stocks on Margin

Buying on margin means that you are buying your stocks with borrowed money.

If you are buying stocks outright, you pay $5,000 for 100 shares of a stock that costs $50 a share. They are yours. You've paid for them free and clear.

But when you buy on margin, you are borrowing the money to purchase the stock. For example, you don't have $5,000 for those 100 shares. A brokerage firm could lend you up to 50% of that in order to purchase the stock. All you need is $2,500 to buy the 100 shares of stock.

Most brokerage firms set a minimum amount of equity at $2,000. This means that you have to put in at least $2,000 for the purchase of stocks.

In return for the loan, you pay interest. The brokerage is making money on your loan. They will also hold your stock as the collateral against the loan. If you default, they will take the stock. They have very little risk in the deal.

One way to think of buying on margin is that it is often comparable to buying a home with a mortgage. You are taking out the loan in the hopes that the value will go up and you will make money. You are in control of twice the amount of shares. All you have to see is the additional profit exceed the interest you have paid the brokerage.

However, there are risks to buying stock on margin. The price of your stock could always go down. By law, the brokerage will not be allowed to let the value of the collateral (the price of your stock) go down below a certain percentage of the loan value. If the stock drops below that set amount, the brokerage will issue a margin call on your stock.

The margin call means that you will have to pay the brokerage the amount of money necessary to bring the brokerage firms risk down to the allowed level. If you don't have the money, your stock will be sold to pay off the loan. If there is any money left, you will be sent it. In most cases, there is little of your original investment remaining after the stock is sold.

Buying on margin could mean a huge return. But there is the risk that you could lose your original investment. As with any stock purchase there are risks, but when you are using borrowed money, the risk is increased.

Buying on margin is usually not a good idea for the beginner or normal, every day investor. It is something that sophisticated investors even have issues with. The risk can be high. Make sure that you understand all of the possible scenarios that could happen, good and bad.

High Growth Stock Purchase

As a highly rated stock both in terms of fundamentals and technicals, True Religion (TRLG), the high end denim jeans retailer, recently surfaced as a top buy candidate in my database of high growth stocks.

As I do with all stocks that appear at the top of my database screens, I pulled up the chart of TRLG in order to get a better read on the health of the stock and to see if there may be a better buy point than what could be had by purchasing at the formal break out (.10 above the high of the handle formation). In this case, the chart looked good with a surge in price and volume in the right side of the base followed by healthy consolidation. The stock consolidated into a bullish triangle continuation pattern where prices converge to a point (forming a triangle) in conjunction with a dry up in trading volume. It's called a continuation pattern because typically the end of the convergence leads to a continuation in the direction of the previous movement (in this case up!!). Of course these patterns aren't ALWAYS successful, but more often than not they are. In the chart of TRLG below (link to image in about author section) you can see today's "continuation" out of this bullish pattern, offering a better buy point then the formal pivot of 17.70.

Once I've located the stock in the SelfInvestors.com database, looked over the chart and determined where an entry point might be, I'll set a real time alert around 1% below the potential buy price. In this case I figured the stock would initially break out of this pattern around 16, so this is where I set my alert. Once I'm alerted to the price, I know the stock may be on the verge of the move I've been waiting for, so I'll begin to watch it closely in real time and have the order information entered, so that all I have to do is click submit once the price is met.

I make buy and sell decisions by looking at a real time intraday 5 minute chart. Below you'll see today's intraday chart of TRLG and the buy point around 16.30 (link to image in about author section).

Yes, bases work on the intraday charts too! See the breakout from the cup base with handle today at around 2:30PM EST? I never make a purchase if a stock has run up in the first half hour to hour of trading and will often wait for the stock to clear the high of the first hour of trading. What the run up early this morning did was trigger my alert at 16, indicating this was one to watch closely throughout the day. Since I now had my high of the day I could set another alert just below that so that I'm not watching it all day (usually I have much better things to do!). I set another alert at 16.20, which it triggered at 1:30PM EST.. and at that point it was time to watch closely for a breakout above the high of the day, which it finally did. I had the order ready and pulled the trigger on the buy.

Hopefully I haven't made this sound more complicated than it is! Do yourself a favor and subscribe to a real time charting service with real time alerts (your broker or trading platform may include this), but a separate program may be best. Esignal and TCNet are popular real time charting systems. I'd also recommend investing in another monitor so you don't have to minimize windows left and right. You can just throw in another video card into your existing computer and pick up a very good CRT monitor for cheap these days. The more computers and monitors, the better! Good Luck!

Make An Intelligent Stock Investment

There's a big difference between buying a stock for a quick trade, and making a true stock investment. With so many friends and neighbors focused on the quick profits of day trading, people have forgotten that making a stock investment makes them part-owners of real, live businesses.

If you view stock investments from this perspective, you need to be concerned about things beyond MACD, support and resistance, and other technical indicators. You have to be certain that the business is one you can entrust with your hard-earned money, for the long term.

Review the Company's Income Statement Before Making a Stock Investment

Day traders almost never bother with financial data, but true investors should always review both the income statement and balance sheet of a company before making a stock investment.

Start by looking at the past three to five years of income sheet data. Is the company's income growing? If so, is the growth accelerating or decelerating?

Always look at the company's gross margins before making a stock investment. Gross profit is the company's total sales minus its cost of goods sold. Gross profit as a percentage of sales is gross margin - is this number going up or down? Once you evaluate all of this information, you will be better prepared to make a stock investment.

If a company's income statement is erratic, income growth is decelerating, and its gross margins are being cramped, it can still be a good stock investment.

This is because other investors have probably abandoned the company, pushing the price of the stock down. Generally, companies that have consistently accelerating growth and improving gross margins are pricier stock investments. You have to evaluate all of the data and determine what you think the stock is really worth.

Don't Forget the Balance Sheet When Making Stock Investments

Reviewing the income statement is never enough when making a new stock investment. The balance sheet is always at least equally important, and in the case of companies with weak income statements, the balance sheet is even more important.

Consider the liquidation value of a company before making a stock investment. This is most important for companies under distress. What would happen in the worst case scenario and the company went bankrupt?

Look at the balance sheet and subtract intangible assets and total liabilities from total assets. What's left are the items that could be sold if the company ceased operations. If the liquidation value per share is close to the trading value of the stock, then you have downside protection on your stock investment.

If you think the company has a chance to turn things around, then it could be a great buy.

Should You Only Look For Damaged Companies When Making a Stock Investment?

No! While the balance sheet is most important when considering a stock investment in companies under distress, the income statement is paramount when making a stock investment in growing firms. Growth stocks aren't just for traders, they can be for investors too!

Consider Hansen Natural (HANS). This stock quadrupled from $7 a share in April of 2004, to $28 per share a year later. This would have been great for a trade, but traders would have really missed out if they sold for $28.

Over the next 15 months, the stock went all the way to $200 per share! Investors who took a look at the company's financial statements and carefully considered its tremendous growth prospects, could have turned a $10,000 stock investment in 2004 into more than $285,000 today.

It pays to buy and hold when you do the homework and you're confident that you're right.