ETFs are securities that trade like stocks on an exchange, but they are made up of multiple securities like stocks, bonds, and currencies. You can trade ETFs whenever the market is open, and you can buy them with cash or a margin account. But should you buy ETFs on margin?
You should avoid buying ETFs on margin because of the risks involved, especially with leveraged ETFs. If you lose money on your ETF, you still need to pay back the amount you borrowed on margin. If you can’t pay it back, you must sell other securities in your account or default on the loan.
This article will explain what ETFs are, what margin buying is, and the risks and possible rewards associated with buying ETFs on margin. There are also some books and video recommendations that you can reference at the end if you want to learn more about ETFs or buying on margin.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Are ETFs and Buying on Margin?
ETFs, or exchange traded funds, are a security or group of securities that track an index or specific group of stocks or bonds. They are traded on an exchange similar to stocks, and the securities within each ETF unit stay the same.
You can buy ETFs with cash, or you can buy ETFs on margin. When you buy ETFs on margin, you need a margin account. Margin accounts allow you to buy securities, including ETFs, using the money you borrow from a brokerage.
To open a margin account, you need to:
- Deposit a minimum amount of cash into your account, usually around a few thousand dollars.
- Buy ETFs by paying for them with part of the cash in your account and part money loaned by the brokerage that your account is managed by. Usually, it is a fifty-fifty split, as margin accounts are not meant to fully cover the cost of your securities.
- You also need to pay interest when you buy ETFs on margin. The money you borrow from your margin account is like a loan, and you need to pay it back, regardless of how well your ETFs do. If you cannot pay the money back, you need to default on the loan, and your credit will be affected.
Why Should You Avoid Buying ETFs on Margin?
There is a risk to consider when you buy ETFs on margin. If your ETFs decrease in value and you lose the money you borrowed, you still need to pay it back.
The minimum amount of cash that you must keep in your account at all times is typically equal to twenty-five percent of your total margin account.
If your ETFs lose value, you need to add more cash to your account or sell some of the securities in your account. The brokerage will give you a deadline to get your account balance back up. If you do not meet the deadline or do not have enough money to put into your account to make up for the losses, the brokerage may sell your ETFs to get their money back.
The money that you pay in interest takes away from your net gain. Even if you make money on your investment, you should be sure that the interest that you pay on the margin account does not take away most or all of your profit. Otherwise, it is a wash, and there is no use buying ETFs on margin.
Finally, there are ETFs called leveraged ETFs which are riskier than standard ETFs. Leveraged ETFs use margin within the fund to have a higher gain than other ETFs, but this also increases the risk of investing in them.
Since leveraged ETFs are already using margin within the fund, you are essentially using double margin, which is very risky if you buy them on margin. The losses that you can face buying leveraged ETFs on margin are high, so brokers limit how much they will let you borrow to buy them in your margin account.
Are There Benefits to Buying ETFs on Margin?
Buying ETFs on margin can turn a profit, even after paying interest on the money you borrowed. Buying ETFs on margin can even make your profit higher than if you did not use margin.
For example, say you have five thousand dollars to invest in ETFs. If you invest it and turn a five percent profit, your net gain is two hundred and fifty dollars.
Now, suppose you have the same five thousand dollars, and you use a margin account to buy another five thousand dollars in the same ETFs. After a return of five percent, your ETF earns five hundred dollars. But, you need to pay interest on the five thousand that you borrowed. If your interest rate is two percent, you will pay one hundred dollars in interest.
Even after your interest payment, you have a net gain of four hundred dollars, which is more than you make without buying on margin.
While there was more risk buying on margin, you ended up with a higher profit.
You can use the money you earned to buy more securities, either on margin or just with cash, or you can keep it as a profit on your investment.
The key to profiting with a margin account is to ensure that the expected gain is higher than the interest you need to pay. If the interest ends up being higher than the net gain, buying on margin is not worth it, and you may even lose money.
However, if you are interested in buying leveraged ETFs, you should buy those with cash and not on margin. Even though the potential gains are high, so is the potential risk, and you can lose all of your money in your margin account on one bad leveraged ETF.
Learn More About ETFs and Buying on Margin
Learning more about ETFs and trading on margin will help you be a better investor. These resources will help you understand ETFs and margin accounts even better:
- This YouTubevideo from TD Ameritrade will teach you the basics of ETFs, how they trade, and what benefits and risks are associated with them:
- Another great YouTube video is from Charles Schwab. It teaches you how margin trading works and how you can benefit from it.
- ETF Investing 101 for the Year 2021 from Amazon.com will help you get started with ETF investing. You will learn how the ETF market works, how to manage your ETF investments and avoid common pitfalls of investing in ETFs.
- Margin Trading from A to Z: A Complete Guide to Borrowing, Investing, and Regulation from Amazon.com will give you a step-by-step guide to margin accounts and how to trade on margin. You will learn about minimum account requirements, how to manage a margin account, and some quizzes to test your knowledge of margin trading.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
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Conclusion
Buying ETFs on margin is risky if you lose money. When you buy securities on margin, you need to pay back the money you borrowed to your brokerage, with interest, regardless of how your investments perform. If you cannot pay the money back, you may need to sell the other securities in your margin account or default on the loan.
If you want to successfully buy ETFs on margin, you need to have an expected return on your investment higher than the interest rate on your account. If the return is lower than the interest rate, you will not profit.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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