Friday, March 21, 2014
Did you know that if you have at least a few thousand dollars in your brokerage account that you might qualify to borrow money against your existing stocks to buy even more? This practice is known as trading on margin. It allows people who want to get really aggressive to buy more shares of a company than they could otherwise afford.
In this article, we discover what margin is, how you can put it to work in your portfolio, the inherent risks and the power of leverage upon your asset base.
The definition of margin
Defined, margin is essentially investing with borrowed money. Any eligible individual may purchase securities on margin by borrowing money from their broker at a fixed interest rate (for example, 9.5%). The rate is determined by each brokerage house and normally decreases as the amount borrowed increases (e.g., an investor borrowing $500,000 will pay a substantially lower rate than one borrowing $5,000).
Margin maintenance requirements
Each brokerage house establishes a margin maintenance requirement. This maintenance requirement is the percentage equity the investor must keep in his portfolio at all times. A house that maintains a 30% maintenance requirement, for example, would lend up to $2.33 for every $1 an investor had deposited in his account, giving him $3.33 of assets with which to invest. An investor with only one or two stocks in his portfolio may be subject to a higher maintenance requirement (typically 50%) because the broker believes the risk of default is greater due to the lack of diversification.
The power of leverage - a practical example of margin in action
A speculator deposits $10,020 into his margin-approved brokerage account. The firm has a 50% maintenance requirement and is currently charging 8% interest on loans under $50,000.
The speculator decides to purchase stock in a company. Normally, he would be limited to the $10,020 cash he has at his disposal. Utilizing margin , however, he borrows just under the maximum amount allowable ($10,000 in this case), giving him a grand total of $20,020 to invest. He pays a $20 brokerage commission and uses the $20,000 ($10,000 his money, $10,000 borrowed money) to buy 1,332 shares of the company at $15 each.
Scenario 1
The stock falls to $10 per share. The portfolio now has a market value of $13,320 ($10 per share x $1,332 shares), $10,000 of that is cash from the margin loan, $3,320, or 25% of the margin loan, is the investor's equity. This is a serious problem. The speculator must restore his equity to 50% within twenty-four hours or his broker will liquidate his position to pay the outstanding balance on the margin loan. This 24-hour notice is known as a margin call. To meet his margin call, he will have to deposit cash or shares of stock worth at least $6,680.
The stock falls to $10 per share. The portfolio now has a market value of $13,320 ($10 per share x $1,332 shares), $10,000 of that is cash from the margin loan, $3,320, or 25% of the margin loan, is the investor's equity. This is a serious problem. The speculator must restore his equity to 50% within twenty-four hours or his broker will liquidate his position to pay the outstanding balance on the margin loan. This 24-hour notice is known as a margin call. To meet his margin call, he will have to deposit cash or shares of stock worth at least $6,680.
Had the speculator not bought on margin, his loss would have been limited to $3,333. He would have also had the freedom to ignore the fall in market value if he believed the company was a bargain. His use of margin, however, has turned his loss into $6,680 plus the commission on the forced sale of stock and the interest expense on the outstanding balance.
Scenario 2
After purchasing 1,332 shares of stock at $15, the price rises to $20. The market value of the portfolio is $26,640. The speculator sells the stock, pays back the $10,000 margin loan and pockets $6,640 before interest and the selling commission. Had he not utilized margin, this transaction would have only earned him a profit of $3,333 before commissions.
After purchasing 1,332 shares of stock at $15, the price rises to $20. The market value of the portfolio is $26,640. The speculator sells the stock, pays back the $10,000 margin loan and pockets $6,640 before interest and the selling commission. Had he not utilized margin, this transaction would have only earned him a profit of $3,333 before commissions.
The lesson
The lesson is that margin amplifies a portfolio's performance; it makes losses and gains greater than they would have been if the investment had been on a strict cash-only basis. The primary risks are market and time; prices may fall even if an investment is already undervalued and / or it may take a significant amount of time for the price of a stock to advance, resulting in higher interest costs to the investor. An investor that found anundervalued stock is speculating ipso facto by using margin because he is now betting that the market will not fall far enough to force him to sell his holdings.
The lesson is that margin amplifies a portfolio's performance; it makes losses and gains greater than they would have been if the investment had been on a strict cash-only basis. The primary risks are market and time; prices may fall even if an investment is already undervalued and / or it may take a significant amount of time for the price of a stock to advance, resulting in higher interest costs to the investor. An investor that found anundervalued stock is speculating ipso facto by using margin because he is now betting that the market will not fall far enough to force him to sell his holdings.
Margin basics
- All securities in your account are held as collateral for a margin loan.
- The margin maintenance requirement varies from broker to broker, stock to stock and portfolio to portfolio.
- If you fail to meet a margin call by depositing additional assets, your broker may sell off some or all of your investments until the required equity relationship is restored.
- It is possible to lose more than you invest when using margin. You will be legally responsible for paying any outstanding debt you may have to your broker even if your portfolio is completely wiped out.
- The interest rate charged by your broker on margin balances is subject to immediate change.
In some extreme cases, margin caused serious economic troubles. During the Crash of 1929 proceeding the Great Depression, maintenance requirements were only 10% of the amount of the margin loan; brokerage firms, in other words, would loan $9 for every $1 an investor had deposited. If an investor wanted to purchase $10,000 worth of stock, he would only be required to deposit $1,000 upfront. This wasn't a problem until the market crashed, causing stock prices to fall. When brokers made their margin calls, they found that no one could repay them since most of their customers' wealth was in the stock market. Thus, the brokers sold the stock to pay back the margin loans. This created a cycle until eventually prices were battered down and the entire market demolished. It also resulted in the suspension of margin trading for many years.
More Information About Trading Stocks
To learn more, read our guide to trading stocks. It will explain some of the basics of stock trading, pitfalls, and much more.