Margin - Double Edge Sword

Introduction

Investment using margin is also known as leverage. Leverage is always a double edged sword and it can bring you faster to attain your financial goal or it can lead to your financial downfall. Margin is a high risk strategy that can yield huge return if executed well. However, if you do not know how to use margin, it can go against you. Hence, I strongly recommend that margin is meant for the seasonal investor.

Buying stock on margin is to borrow the stock from your broker, it allows you to buy more than your usual limit. However, this requires you to pledge either cash or stocks. Your broker will require you to sign a legal contract to open a margin account. For Lim & Tan, you need to pledge at least $5,000 of cash or $10,000 worth of stocks. It is important to know that you do not need to margin all the way, you can borrow less, say 10% or 25%.

In addition, there is an interest charge on the loan amount. Over time, the interest expenses may become larger than your stock appreciation, this will result in a loss. If your debt increases, the interest charges will increase. When you sell the stock in margin account, the proceeds go to your broker until it is fully paid and redeemed. In addition, there is a maintenance amount which is the minimum amount that you need to have before your broker will force you to top up in cash or force sell your stock. This is known as margin call. Not all the stocks will be qualified for margin, you need to check with your broker and there is a limit to the each individual counter depending on the quality of the company.

An Example

For instance, you deposit $10,000 in your margin account. In Lim & Tan, cash deposit allows up to 3.5 times purchase power and for shares collateral allows up to 2.5 times purchase power. Hence, this allows you to purchase shares up to $35,000. If you buy $5,000 worth of stock, you still have $30,000 in buying power. You have enough cash to cover this transaction and has not tapped into your margin, you start the borrowing process when you purchase more than $10,000.

What is margin call?

The initial margin is the initial amount you can borrow and the maintenance margin is the amount you need to maintain. For Lim & Tan,  the maintenance margin is at 40%. If the equity of your account falls below the maintenance margin, the brokerage firm will issue a "margin call". A margin call forces the investor to either liquidate his position or top up with more cash in the account.

For instance, you purchase $35,000 worth of securities by securities by paying $10,000 of yourself and borrow $25,000. If the market value of securities drops to $30,000, the equity in your account falls to $5,000 ($30,000 - $25,000 = $5,000). Assuming a maintenance margin requirement of 40%, you must top up additional $2,000 to meet $12,000   (40% x 30,000 = $12,000). The brokerage will issue you a margin call. If the brokerage firm sells your stock, you will not have control over which stock is sold to cover the margin call. It is imperative to read the terms and conditions of the margin contract you signed to understand thoroughly the calculation of interest, the collateral of the loan and repayment of the loan.

The advantage of margin

Companies borrow money to invest in projects, people borrow money to buy properties, investor borrow money to buy stocks.  By having more money through margin, you can either trade or hold for long term position. Assume you borrow $20,000 worth to purchase securities of Super Group shares which is trading at $1 and you feel it will rise dramatically. You have only pump in $10,000 of cash and leverage 50%. Normally with $10,000 of cash you can only purchase 10,000 shares (10000 x $1), with margin, you can purchase 20,000 shares. If the company announce strong performance in performance, the share price double to $2, your investment is worth $40,000 (20000 x $2). After paying back $10,000, you still have $30,000 which is equivalent to $20,000 of profit. This example excludes commissions and interest to simplify the illustration. Similarly, the losses will be amplified if the share price drops.

Margin for the young investors

Young investors in their early 20s with just a few thousand dollars in the market will not have very much diversification and they are underinvest in the market for the first 25 years of their working life. The only way for young investors to have more exposure to the market is to deploy a little leverage. You can deploy 2 to 1. When go to 3 to 1 or higher will make leveraging more expensive, the power of diversification will be eroded due to cost of borrowing. The increased market exposure when young allows you to have less exposure later on, market in the long run will recover any short term losses and bull market is always longer than bear market. However, if the young investors have credit-card debt, then they should clear their debts first before moving to margin.

Conclusion

Investors regardless of age need to be educated financially and need to be disciplined when deploying margin to buy stock to reduce and control risk to succeed in purchasing stocks with margin.