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Okay, Dear Students, we are ready to learn how to borrow money to buy stocks, commonly referred to as buying on margin. If you borrow money to buy stocks ‒ buy on margin ‒ not only will your brokerage firm be earning commissions from you but you will also be paying them interest! This will make your broker very happy. What’s that, you say? You say you are really not that interested in whether or not your broker is very happy and you are more concerned with your own financial success. My apologies. Well, did I mention that buying on margin can magnify your investment returns? Yes, indeed, it can! But I guess I also have to mention that buying on margin can also magnify your investment losses. Oh, well, nothing is perfect!
A cash account is a brokerage account in which all transactions are made on a strictly cash basis. Cash accounts are the simplest arrangements requiring no credit check of the customer by the brokerage firm. Once you have established a good relationship, most brokerage firms will allow you to purchase shares of stock even if you do not have enough cash in the account. This is because stock transactions settle in two business days. You have two business days to get the money into the account. Some of the deep-discount Internet brokers do not allow this. The cash must already be in your account. Conversely, when you sell a stock, it takes two business days to receive the money. Again, once you establish a good relationship with your brokerage firm, if you need the money sooner than two days, they will usually make arrangements so that you can immediately have access to the proceeds from the sale of the stock.
A margin account is a brokerage account in which, subject to specified limitations, securities can be bought and sold on credit. If you open a margin account, the brokerage firm will do a credit check to determine your creditworthiness, since you will be borrowing money from them. The interest rate you pay on the money borrowed from your broker is called the margin rate. It is actually a very good interest rate. It is often the prime rate plus 1 or 2 percentage points or 2 or 3 points above the current money market rates, depending on how much you borrow. The margin rate is almost always much better than credit card rates.
A margin account allows you to perform margin trading, commonly referred to as buying on margin. Buying on margin entails the use of borrowed funds from your broker to purchase securities, typically stocks. Hence, your account is often referred to as a leveraged account. You can use the borrowed funds as a lever to magnify your returns by reducing the amount of equity that you must deposit. Of course, leveraging as it is often called is a two-way street. The use of borrowed funds can magnify your returns but it can also magnify your losses. Ain’t nuthin’ free!
The margin is the portion of the value of your investment that is not borrowed. (This has always seemed odd to me. Shouldn’t it be the other way ‘round? Shouldn’t the part that you borrowed be called the margin?) The margin is the amount of equity stated as a percentage in the investment. An example would be if you bought a stock for $100 and you deposited $75 and borrowed $25. Your margin would be 75% while 25% of the investment is money you borrowed from your broker.
The Rationale for Buying on Margin
Why buy on margin? Buying on margin allows the investor to use financial leverage. (There’s that word again, leverage!) Leverage is the use of debt financing to magnify investment returns. We will see some examples shortly. Another use of buying on margin allows an investor to tap into the equity in their account without actually selling their investments and generating commissions and taxable transactions. Buying on margin is much like buying a house. When you purchase a house, you do not come up with the total amount. You deposit 10% or 20% down and finance the rest. However, when you buy stocks on margin, you are required to deposit at least 50%.
Generally, at first, a prudent, long-term investor would avoid buying on margin. We will see examples of why it is best to avoid buying on margin very soon. However, there may be situations where buying on margin is a suitable strategy. Let’s say an investor has built a solid, long-term oriented portfolio of high-quality stocks from many years of prudent and successful investing. The investor has an unforeseen incident which now requires a large purchase or outlay. The investor, though, does not want to sell their stocks. This would generate commissions and taxes and also, maybe they just believe that these are stocks that they want to continue to hold for the long term. The investor can use buying on margin to borrow on the value of their portfolio, similar to a Home Equity Line of Credit (HELOC) loan that homeowners can employ when in need of cash.
The important point to remember here is that in both cases, you are borrowing money, whether it is a HELOC loan from your bank or credit union or a margin loan from your broker. In our BUS-121, Financial Planning and Money Management, class, we recommend that our students follow this tried and true saying, “Make Love, Not Loans.”
The Aspects and Mechanics of Buying on Margin
As mentioned, buying on margin requires an initial deposit called the initial margin. This initial margin requirement is the minimum amount of equity that must be a margin investor’s own funds. The initial margin requirement is set by the Federal Reserve Board and can change over time but has been set to 50% for many decades. You must deposit at least 50% of your own funds. This allows you to purchase the same amount of stock with half the money. The margin loan, also known as the debit balance, is the amount of your account borrowed.
Let’s take a look at an example. You deposit $10 and borrow $10 from your broker. You purchase one share of common stock for $20. Your initial margin is $10 or 50%. The margin loan is $10 or 50%. Now let’s say the market price of the stock rises to $30. Congratulations! You made $10 on a $10 investment! That is half of what you had to come up with when you simply purchased the stock outright with your own money. Instead of a 50% return on your investment, you received a 100% return on your investment.
Let’s revisit the example, you deposit $10 and borrow $10 from your broker. You purchase one share of common stock for $20. Everything is the same as before, however, this time the market price of the stock drops to $10. Oops! Only ½ of the money was yours! You borrowed the rest. You have lost your entire investment! Buying on margin magnifies your gains and magnifies your losses. Margin buying was one of the major contributing factors to the Crash of 1929. At the time, the margin requirement was only 10%. For this reason, the above scenario is prohibited today and our intrepid investor would have had a “margin call” long ago.
Because margin trading is inherently more risky, margin accounts are more highly scrutinized by brokerage firms. A restricted account is a margin account whose equity is less than the initial margin requirement. The investor may not make further margin purchases and must bring the margin back to the initial margin requirement when the securities are sold. Information technology has made the brokerage firm’s job of scrutinizing margin clients much easier. Now, the computer spits out a list of customers that are restricted.
The maintenance margin is the absolute minimum amount of margin that an investor must maintain in the margin account at all times. The Federal Reserve Board sets the minimum and it has been set at 25% for many decades. However, your brokerage firm may set the minimum higher for individual clients depending upon their creditworthiness. A client’s maintenance margin might be set at 35% or 40% if the brokerage firm believed that the client would have trouble absorbing the very large losses that may accompany a margined transaction.
If the amount of margin falls below the maintenance margin, the investor will receive the dreaded margin call, a notification of the need to bring the equity of an account whose margin is below the maintenance level up to the initial margin level or to have enough margined securities sold to reach this standard. If the investor does not meet the margin call in sufficient time, typically 48 hours, the brokerage firm is authorized to sell enough of the securities to meet the margin call. There is an old Wall Street saying: “Never meet a margin call!”
As the Internet bubble was deflating in the early 2000’s and many technology firms were seeing their prices plummet, some brokerage firms would send out the margin call notifications in the form of email messages overnight. However, the brokerage firms did not wait for the clients to respond. Immediately, when the market opened the next day, the brokerage firms sold the losing shares in an effort to stem the clients’ losses. How could they do this? When you open a margin account, you agree to many provisions that state that the brokerage firm is allowed to close out your transactions without your consent or approval. Why did they do this? They did this to protect themselves. If stock prices fall fast enough, an investor might lose enough money such that they now have what is called negative equity. This is a fancy term for having all the value of their portfolio wiped out and now they are losing borrowed money. If they disappear or declare bankruptcy, the brokerage firm is on the hook for the loss.
Of course, if your investments do very well, you will have excess margin in your margin, more equity than is required in a margin account. You can then use the excess margin you create in your margin account to purchase additional stock without having to come up with more money. This is called pyramiding, the technique of using excess margin from paper profits in margin accounts to partly or fully finance the acquisition of additional securities. What do you think of this strategy? Sorta’ flies in the face of, “Make Love, Not Loans,” eh?
And remember that you have borrowed money from your brokerage firm. You are paying interest on that borrowed money. Paying interest on the margin loan also adds yet another drag on your investment returns. Your margined investments must meet or exceed the margin interest rate in order for you to just break even! Commissions and interest, what a combination! Now you know why your broker is always so happy to take your calls.
You might be asking yourself the question, “So, why would I buy on margin?” The easy answer is, “You shouldn’t.” The risks are not worth the potential reward, in the opinion of Your Humble Author. Of course, you will find many other more adventurous individuals who disagree and believe buying on margin is worth the risks. Do you want to eat well or do you want to sleep well?
However, as discussed, there is a valid, logical reason for having a margin account. A margin account allows you to temporarily borrow against your investments without having to sell them. You do not incur commission costs and you do not trigger capital gains taxes, but you do pay interest. Do you think you would want to buy stock on margin?
The Account Balance Sheet
Traditionally, with margin accounts, the brokerage firms would create an account balance sheet to keep track of the account. It is all computerized now. Those of you with accounting experience will recognize this as a simple balance sheet using the formula:
Assets = Liabilities + Equity
The assets on the left of the account balance sheet must equal the liabilities and equity on the right of the account balance sheet. The account balance sheet also makes it easier to calculate the margin. To calculate the account margin, we use the formula:
Account Margin = Account Equity / Total Assets
Let’s take a look at an example and construct the account balance sheet. (Relax. We won’t be doing this in our class. None of these calculations will be on the final exam.) You purchased 100 shares of a stock at $100 per share. That is $10,000 in total. You deposit $5,000 and you borrow the rest, another $5,000. You owe your brokerage firm $5,000. You are, of course, paying interest on the $5,000.
|Assets||Liabilities and Equity|
|100 Shares @ $100/shr||$10,000||Margin Loan||$5,000|
|Total Assets:||$10,000||Total Liabilities and Equity:||$10,000|
Using the formula for the account margin above, we get:
Account Margin = Account Equity / Total Assets = $5,000 / $10,000 = 50%
Now what if the stock price rises to $120 per share?
|Assets||Liabilities and Equity|
|100 Shares @ $120/shr||$12,000||Margin Loan||$5,000|
|Total Assets:||$12,000||Total Liabilities and Equity:||$12,000|
Using the formula again for the account margin above, we get:
Account Margin = Account Equity / Total Assets = $7,000 / $12,000 = 58.33%
Congratulations, you have excess margin! You can use the excess margin to help purchase additional shares of stock. But what happens if the stock price drops to $60? Your company was caught artificially inflating earnings!
|Assets||Liabilities and Equity|
|100 Shares @ $60/shr||$6,000||Margin Loan||$5,000|
|Total Assets:||$6,000||Total Liabilities and Equity:||$6,000|
We have a problem. The results from the formula for the account margin are now quite different:
Account Margin = Account Equity / Total Assets = $1,000 / $6,000 = 16.67%
Margin call! Unless your brokerage firm already sold the shares before giving you a chance to respond, you have a choice. You can either sell the shares and take a brutal loss. Or you can meet the margin call by depositing more cash into your account. What was the old Wall Street saying? “Never meet a margin call!” Take the loss and vow never to buy on margin again.
Final Thoughts Regarding Buying on Margin
Do you want to eat well or do you want to sleep well? Buying on margin allows an aggressive investor to magnify their returns but also magnify their losses. Of course, once a prudent, long-term oriented investor has built a solid portfolio of high-quality stocks and is in need of cash, the investor can borrow from their portfolio at attractive interest rates without the need to sell stocks generating commissions and taxable transactions. (And if you dared to say to yourself, “Oh, I don’t pay commissions,” then shame on you! Robinhood has brainwashed you!)