Margin Effects on Return On Investment - ROI

Margin increases the rate of return on investment, if the investment is profitable, but increases losses, if not. Furthermore, transaction costs, margin interest, and any dividend payments for shorted stock subtract from profits but add to losses. Any dividends received from purchased stock will increase profits and reduce losses. For a purchase, the rate of return is determined by the following equation:

Long Rate of Return = (Stock Sale Price + Dividends Received - Stock Purchase Price - Margin Interest) / Amount Invested

For instance, if you purchased $10,000 worth of stock with cash and the stock rises to $12,000, then your return on investment is:

Rate of Return = ($12,000 + 0 - $10,000 - 0 ) / $10,000 = $2,000 / $10,000 = 20%

If instead of paying cash for the stock, you pay $5,000 cash and use $5,000 of margin, then your rate of return, ignoring margin interest to simplify things:

Rate of Return = $2,000 / $5,000 = 40%

As you can see, using the maximum amount of margin almost doubles your rate of return if the holding period is short enough to keep margin interest negligible. From this example, you can also clearly see that if the value of the stock decreased by $2,000 instead of rising, then there would be minus signs in front of the rates of return. Furthermore, margin interest increases potential losses and subtracts from potential profits. To illustrate, if your broker charges 6% annual margin interest and you hold the stock for 1 year, then your broker will charge $300 of interest for the $5,000 you borrowed for 1 year. Thus, the rate of return if stock is sold for $12,000 is:

Rate of Return = ($12,000 - $10,000 - $300) / $5,000 = $1,700 / $5,000 = 34%

If the stock is sold at a loss for $8,000:

Rate of Return = ($8,000 - $10,000 - $300) / $5,000 = -$2,300 / $5,000 = -46%.

The longer the margin is borrowed, the more margin interest will decrease any potential profits and increase potential losses.

Note that the equation for shorted stock would be slightly different, since, as a short seller, you must pay any dividends to the lender of the stock that the lender would have otherwise received, but you do not have to pay margin interest. Thus, the equation for the rate of return for the short seller is:

Short Rate of Return =

Stock Sale Price - Dividends Paid - Stock Purchase Price ───────────────────────────────────────                                Amount Invested