Wednesday, September 9, 2015

Lessons of an Investing Addict Part 3: Margin

Using "margin" means borrowing money from your broker to purchase more stock than you could afford using only your available cash.  Think of it like a credit card that you can only use to buy stock.  In this case, there can be a tremendous upside to taking the risk of utilizing margin, but there is also a significant downside if the investment goes against you - even more of a downside than just the interest you pay on the borrowed money.

The Federal Government (Regulation T) allows you to borrow up to 50% of the initial purchase price of a position, called "initial margin".  Beyond that requirement, brokerages require a minimum equity maintenance to be kept to minimize potential losses to you and to them.  These minimum maintenance requirements can vary.  For example, some brokerages require a 50% equity maintenance on securities selling between $3 and $5 and 30% requirement for equities selling above $5.  These rates are solely at the broker's discretion and some of them tend to be more upfront than others.  (This is one of the reasons that I pulled most of my money out of Scottrade and switched to a different broker, as they revised their maintenance rates for individual stocks weekly, making it impossible to accurately manage an account).

If your equity falls below the minimum requirement, a margin call will be issued and you will either need to deposit more funds, deposit securities, or sell out some of your position to bring your equity above the maintenance requirement.  Don't forget, you'll need to pay interest on the borrowed money!  The interest rate is typically on a sliding scale where a lower rate is paid the more you borrow.  The highest rate may be applied to loans less than $10,000 and currently sits between 7.5% and 8% (better than a credit card, but not by much!).

If all of this sounds confusing, it definitely can be - but I'll try to clarify with examples:

Let's say you have $10,000 to buy stock ABC at $7.50.  However, you've done your homework and are confident in your investment.  Since ABC is selling for above the $5 limit your broker set, you can borrow money on 50% margin to purchase additional stock, but you must maintain a 30% minimum equity. 

So, you have $10,000 cash and you can borrow up to 50% of the total purchase price for the initial margin requirement; you can afford a $20,000 purchase ($10,000 cash, $10,000 borrowed that you are getting smacked with 8% annual interest on).  For $7.50 per share, you can buy 2,667 shares of ABC. 

Let's say you made a good call and ABC goes up to $10.  You decide to sell out for $26,670.  You still have to pay back the $10,000 that you borrowed, so you are left with $16,670, or $6,670 profit.  Not bad!  Say you hadn't borrowed any money and only bought what you could afford with cash.  You would have been able to afford 1,333 shares and would have sold out for $13,333, or a $3,333 profit.  Still not bad, but you would have doubled your profit had you borrowed the money!  See why buying on margin is enticing?

Obviously, there's a downside risk, as well.  Say ABC drops to $5.10.  Your 2,667 shares are now worth only $13,602.  But - OH NO - you still need to pay back the $10k you borrowed!  Your equity out of the $13,602 is only $3,602 (since you still owe the borrowed $10k).  But never fear . . . you are confident ABC will go back up.  But wait!  The phone is ringing!  It's your broker telling you your equity of $3,602 is below the 30% requirement!  ($3,602/$13,602 = 26.5% < 30% = $4,080).  If you can't stomach it and entirely sell out at this point, you'd lose a staggering $6,398 (that's, $10,000 initial investment - $3,602 remaining equity)!

If you do hold on, you still need to meet the 30% margin call.  You either need to deposit another $478 ($4,080-$3,602) into your account or you need to sell securities to bring your equity percentage back up.  If you sell 313 shares to pay back some of the money you borrowed, your total account will drop to $12,005 (that is, $5.10 * 2,354 remaining shares) and your equity of $3,602 is back to the acceptable 30% range.  You still owe ($10,000 - (313)($5.10)) = $8,404 of borrowed money.  If you luck out and ABC appreciates back to $7.50/share, you would only have 2,354 shares left, for a total account value of $17,655!  Once you pay back the remaining $8,404 of borrowed money, you STILL lose $751 (that's, $17,655-$8,404 borrowed = $9,251.  $10,000 initial investment - $9,251 remaining = $751 loss AT THE PRICE OF YOUR INITIAL PURCHASE)!  If ABC kept going down, this process would exacerbate, as you would reach this specific brokerage's 50% requirement for a stock below $5!  And so on and so forth . . .

If you didn't borrow on margin, you wouldn't have had to sell out shares at $5.10 and you would break even if ABC reached $7.50 again.  If you sold out at the $5.10 bottom, you'd lose $3,200; not insignificant, but only half of what you'd lose if you had sold out in the margin account.

Margin is risky, but offers higher rewards as a consequence.  It is NOT recommended beginning investors.  In fact, there are very few occasions where it IS recommended.  For example, in situations where you plan to pay back the borrowed money in the short term, margin can be beneficial.  Regardless of whether you plan to borrow the money in the short or long term, DO YOUR HOMEWORK!  Think of it this way:  Your investment must return 8% to just break even!  It must return 16% to keep up with the market after subtracting out your interest rate!  Ouch!  I'm not saying that there aren't investments that offer the fantastic returns that would make this strategy viable, but they are few and far between.  You REALLY need to know your investment inside and out. 

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