Margin trading involves borrowing funds to buy stocks, bonds or other financial instruments. Like any investment, it involves risks and rewards. The risk is that you might borrow money on a company whose stock price collapses. The reward is that you might borrow money in a company that not only sees its stock price rise, but also pays dividends to shareholders. You can keep dividends in margin trading, but the exact amount you keep depends on your agreement with your broker.
When you trade on margin, you borrow money from your brokerage firm to buy more stock than you could with just the cash in your account. For example, if a stock trades at $30 per share and you have $3,000 in your account, you can buy 100 shares when paying cash. A $1 advance in the stock will result in a gain of $100. If you have a particularly positive outlook on the stock, however, you can borrow an additional $3,000 from your brokerage and invest all $6,000 in the stock. This would enable you to buy 200 shares. The same $1 advance in stock price would greatly improve your personal gain. Any loss, however, will also be larger.
Dividends are used by companies to share their profits with shareholders. A dividend payment occurs by way of cash transfer from the firm's bank account to your brokerage account. When you hold 200 shares in your account, it does not matter whether you paid cash to acquire them or borrowed half of the money from your broker. In either case, you are entitled to dividend payments. When the firm transfers cash to stockholder brokerage accounts, you will receive the dividend payment for all 200 shares.
Whenever you borrow money, you will pay interest. A margin account is no exception. Your broker will charge interest on the $3,000 loan you took out when buying the stock mentioned in Section 1. This is why your profit from a $6,000 investment isn't exactly twice as much as on a $3,000 investment. Assuming an $8 flat commission per trade, buying 100 shares with cash at $30 a share, then selling them at $31, results in a net profit of $84. This includes the $100 gain from the stock price increase, less the $16 in commission fees for buying and selling the stock. Following the same example, say you borrowed $3,000 to buy $6,000 worth of stock at $30 a share. You get 200 shares. Assume 1 percent interest on the loan and a month between the purchase and the sale. If the stock price rises to $31 a share and you sell, your gross profit is $200. But then you have to subtract the $16 commission fee as well as the $30 interest expense. This makes your net profit $154.
Dividends in Margin Accounts
The interest you must pay for a margin account results in an additional complication when you hold a dividend paying stock. Although you are entitled to and will receive all dividends when holding stocks in a margin account, you might not see the associated cash in your account balance. This is because the broker might grab those cash dividend payments to cover the accumulated interest expense. Whether your broker can do this depends on your margin account agreement, so read the fine print.
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