TheStockAdvisor Advice


Look Before You Leap!

The concept of "Trading on Margin" is not a new one, in fact it has been employed by professional traders throughout the 20th Century and probably since they began trading securities under the Buttonwood tree on Broad and Wall Streets.

What is of more current vintage is the widespread advent of "day trading" by a growing cadre of self-styled market experts, either through newly created firms that provide trading facilities for such traders or those who rely on internet connections to trading sites. In order to maximize the wealth creation potential of their new venture, many of these "traders" have also learned a new word, "leverage".

In effect, they found you can invest more money than you have and "double your profit" by borrowing from the broker, or by "buying on margin". Of course, the possibility of also doubling losses is usually not considered, because it is not an acceptable alternative, even though it is real. The Federal Reserve System through its policy setting Open Market Committee, determines how much brokers and investment banks can lend their client against their investments. This percentage is called the margin rate. At present, the rate is set at 50%. This means that for every one dollar in actual value an investor has in his account, he can borrow another dollar. If an investor has 100 shares of fully paid IBM shares in his account, he can in effect purchase another 100 shares just by using margin.

Of course this is not a freebie. The extra funds are a loan from the firm to the investor and he is charged interest on this balance on a monthly basis. The rate is often pegged to the Broker Call Loan Rate, currently at 7.0% or the prime rate, which is currently at 8.25%. Many firms are presently charging in the area of 7.75% to 7.80% for variable rate funds in margin accounts.

Rules governing margin trading will vary from one firm to another. Some may require that an account to have a minimum balance level before they will grant margin. Some may not lend the full 50% or require some additional assets be kept on deposit.

One of the key elements of a margin account is the fact it is repriced or "marked to market" every night. If the value of the investment has declined from its initial purchase level, the amount of borrowed money will suddenly represent more than 50% of the total value of the assets. In such a case, the client will be subject to "Maintenance Margin" requirements imposed by the NASD, NYSE or the brokerage firm.

If the amount of equity relative to the amount borrowed falls below the maintenance level, the investor will quickly receive a call from the broker informing him that he must come up with additional cash to cover the margin shortfall. If he can’t provide additional cash, the firm will sell a sufficient number of shares to cover the difference. If the decline is severe enough, the investor will be called upon to make successively larger payments to maintain the position, even as losses mount.

Conversely, if the price of the shares increase, the investor may use the paper profits to increase borrowings and obtain more leverage. But what must be kept clearly in mind at all times, is that the amount borrowed on margin is constant. Whether the price of the shares go up or down, the loan stays the same. For its part, the firm extending the credit has to insure that the total value of the portfolio (the shares purchased with cash and those bought on margin) is sufficient to pay off the margin loan. If the cash value of the shares sink, the investor has to sink in more cash.

It is always good investment strategy to employ stop-loss orders (see our tutorial on that topic), but when trading on margin it is virtually imperative that such a strategy is employed. Every dollar decline in the price of the investment is actually a $2 loss thanks to the benefits of margin leverage. Few investors can afford to get too far behind in the count with leveraged accounts. Failure to employ prudent investment strategies, can prove very painful.

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