Turbo charge your returns, but be careful of the added risk
Margin is a term used in the financial markets to describe the practice of only paying an initial amount for the purchase of a financial product and the balance is never paid.
Numerous financial products can be bought on margin, such as stocks, mutual funds, Exchange Traded Funds (ETFs), commodities such as oil or gold, and currencies to name a few. The focus of this article will be on purchasing stocks on margin.
When an investor buys a stock on margin, they only ever pay the deposit which for a standard brokerage account is a minimum of 50%. The deposit is referred to as either a margin deposit or the initial margin. The balance is paid from a loan that is made by the investor’s broker and financed by the broker’s bank. The loan (which is known as a margin loan) is secured with the stock as collateral. Interest is charged on the loan balance at the prevailing interest rates, which tends to be amongst the cheapest of loans available (due to the ease of liquidating stocks, thus reducing the risk to the lender).
The maximum an investor can borrow with a margin loan is set by the Federal Reserve Bank (the Fed) with a regulation known as a Regulation-T, which restricts ordinary investors from borrowing more than 50% of the stocks purchase value. This is intended by the Fed to limit the amount of risk that an investor can take on.
Buying on margin of 50% will effectively double the amount of stock that can be purchased with the cash they have in their account. The investor will therefore receive twice the amount of dividends paid, but will have to pay interest on the 50% that was borrowed to settle the stock purchase. Any capital gains made are doubled, but any losses made are also doubled. Therefore it is not a free lunch and here is where the risk lies with buying stocks on margin.
If a portfolio of stocks bought on 50% margin goes up in value, everything is fine and investor really as a nice double boost to their capital gain. The problem is if the value of this margined portfolio of stocks actually goes down (and it’s a big problem!).
The portfolio value is calculated daily by the broker from the closing stock prices. If stock prices fall and the portfolio value drops below a threshold level, the investor is faced with what is known as a margin call.
A margin call simply means that the broker no longer considers the investor’s portfolio to be sufficient collateral for the money the broker lent the investor.
If the broker imposes a margin call, the investor has three options.
Receiving a Margin call:
- The investor can sell sufficient shares to reduce the loan balance. The money received from the stock sold is used to pay down the loan balance.
- The investor can deposit sufficient cash into their brokerage account to make up for the lost value in the stocks. The portfolio value is actually the sum of the stocks value and the cash balance.
- The investor can do nothing and the broker will sell sufficient shares to reduce the loan balance. The money received from the stock sold is used to pay down the loan balance.
When an investor receives a margin call, they do not have any time to waste. Typically, if the margin call is not resolved by the investor the next day, the broker will sell down the investor’s stocks.
While margin calls are not pleasant, they do
help investors to preserve their capital
While an investor can theoretically buy stock up to the maximum limit, it is a sure fired way of triggering a margin call as there is no allowance for market volatility. Professional and experienced investors keep a comfortable level of safety that allows for the market’s fluctuations.
Buying on margin has its advantages and disadvantages. While the upside potential is fantastic, the stock investor needs to determine for themselves if they can emotionally handle the disadvantages, since the value of a portfolio tumbles far more quickly when on margin and to make things worse, the investor has to pay loan interest on top of their losses.
The possibility of a margin call is always there and it’s a part of investing with borrowed money. Basically, the closer to the maximum limit the investor gets, then the higher the likelihood that they will be faced with a margin call. If the prospect of a margin call would cause the investor some concern or distress, then it would probably be better if the investor avoided buying stocks on margin.