TRADING on MARGIN
Double your PLEASURE or DOUBLE TROUBLE?
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
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 cant 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.