Have you ever heard about people making, or losing, a lot of money quickly by trading on margins? If you wondered what that means, grab your reading glasses and some popcorn. It is time for Margin Trading 101.
Investopedia gives a good introduction to the idea of how margin trading works on the surface:
Imagine this: you’re sitting at the blackjack table and the dealer throws you an ace. You’d love to increase your bet, but you’re a little short on cash. Luckily, your friend offers to spot you $50 and says you can pay him back later. Tempting, isn’t it? If the cards are dealt right, you can win big and pay your buddy back his $50 with profits to spare. But what if you lose? Not only will you be down your original bet, but you’ll still owe your friend $50. Borrowing money at the casino is like gambling on steroids: the stakes are high and your potential for profit is dramatically increased. Conversely, your risk is also increased.
When you trade on the margin, you are borrowing cash from the brokerage firm to use in the stock market. To trade on margins, you will need to be approved by your brokerage. I would not do this unless you are super rich and can afford to lose 75% of what you borrow. I would never short sell or buy anything other than large cap equities (stocks), but that might just be because I am afraid of losing everything I have.
When someone is setup for margin trades, they are given a limit (like a credit limit) and terms for what is essentially a loan. To explain how it works, I will give an example of what an investor might go through when borrowing and investing on the margin. These are completely made up numbers and do not necessarily represent fair or realistic terms. I am just using round numbers because they are easy:
Joe Investor has an account at Online-Broker-Company (OBC). Joe has a portfolio of $500,000 in an account at OBC that is invested with $400,000 in stocks, $50,000 in bonds, $10,000 in options, $30,000 in mutual funds, and $10,000 in cash. Joe has had the account with OBC for five years and is an active trader (10+ trades per month).
Joe is doing some fundamental analysis and finds that stock XX is worth $20 per share, but is trading at $10 per share. He also finds, using technical analysis, that the stock is likely going to trend upward over the next few days up to $17 per share. Because he only has $10,000 in cash on hand, and he is certain of his estimates, Joe borrows funds from OBC that allow him to invest as much as possible into the stock.
Joe is required by OBC to invest 20% of his own funds for any margin buy, that is called the margin requirement. Therefore, Joe can borrow up to $40,000. Joe is approved by OBC for the margin purchase and is allowed to purchase $50,000 in stock XX with the $10,000 in his account. He is also required to maintain a portfolio of at least $50,000 at the company as collateral in case the stock price goes down to zero. He is considered to be 80% leveraged at this point.
The stock goes up to $25 per share and Joe gets greedy. He could sell the stock and take the $15 per share, or 150% profit, and leave the transaction that cost him $10,000 with $125,000. Joe doesn’t. He decides, despite his analysis that the company is worth $20 per share, to stick it out.
The next day company XX goes bankrupt. No one saw it coming. The stock plummets in one hour to $1 per share. All of a sudden, Joe’s $50,000 investment is worth $5,000. He not only lost his own $5,000, he owes OBC $40,000 that he borrowed. OBC will initiate a margin call, which is a request for Joe to give the firm the cash needed to bring his margin rate back to 20%. Because of the large loss (90%), he has to come up with a lot of cash quickly. If he can’t, OBC will sell $35,000 of Joe’s other investments and take his $5,000 cash to cover their loss.
This example is extreme, but it is possible. Margin trading can give you a huge payday or a huge loss in very little time. Your investment company is not the mafia and will not cut off your hand or kill you for losing their money, but you are legally responsible for paying them back. If you try to take your assets and run, they can sue you, and will win, for the amount of their loss.
If you have something to add or any questions, please let me know in the comments. If you enjoyed the post, consider following the blog by e-mail (using the form on the top right of the screen) or RSS. Also, take a look at the well written comments that explain some of the complexities of margins in more detail.