RIYADH, 3 January 2005 — Soon after you make your few initial securities trades, your investment broker entices you to expand the boundary of your account by offering you a line of credit, a loan, using the assets in your account as collateral. This is referred to as trading on margin, or your account becomes a margin account. So instead of trading with your invested capital of say $100,000, you’ll now be able to trade with $150,000. Sounds tempting doesn’t it?
Investors can borrow money, using the equity in their account as guarantee, to buy stocks whose total value is higher than the asset value of their portfolio. In doing so, they are leveraging their portfolio purchasing power. At the completion of the transaction, buy or sell, the investor will have to pay back the borrowed funds plus the interest for the duration of the loan. If an investor wants to buy 200 shares of say Dell Computers at $50, but have only $5,000, then he needs to borrow another $5,000 to complete the transaction.
If he sells the 200 shares later on at the price of $60 a share, then his gross profit for the transaction will be 40 percent i.e. 100x(200 x (60-50)/5,000), instead of 20 percent has he only invested his own funds. Obviously interest expenses and commission will be deducted from his gross profit. If alternatively he sold his shares at $37.5, then instead of loosing 25 percent, his actual loss will be 50 percent.
Buying on margin is very risky particularly that most investors focus only on price appreciation. If the stock price that is bought on margin drops to a low level that selling it will not be enough to repay the loan to the broker, then the broker issues a margin call to the investor. The investor will then have to promptly deposit additional money in his margin account to cover the difference. If he or she cannot meet the call, then the broker will sell enough shares at the then current low price to get part of his loan, even if the stock was expected to rise again. During market corrections, many leveraged investors get into trouble and are forced to sell most of their portfolio at a low price in order to cover their margin calls.
Margin trading is risky but can be useful as long as you are able to make a profit, on your borrowed capital higher than the interest and commission that you broker charges you.
If you make less, then instead of leveraging your profit you end up increasing your loss. Investors usually use their investment power, including all their lines of credit, faster than they imagine. This is a result of basic human instincts, which enjoys continuous action — in this case buying. Accordingly people find that they get fully invested most of the time, i.e. they quickly utilize any new funds or credit line provided to them.
Sooner or later the shares you own drop in value on their own or due to a market correction. Consequently the value of your portfolio goes down and so does the limit of your margin. Immediately you will be faced with a margin call, maintenance call, requesting you to deposit additional funds within hours, to cover your exposure — overdraft. If you fail to do so, like most investors, your brokerage firm will sell enough equities from your portfolio to cover your overdraft on your credit limit. Obviously any such sale will be at the then current depressed market price. Margin calls force many people to liquidate their portfolios and have frequently caused excessive selling pressure which leads to a vicious cycle of selling in a rapidly collapsing market. In summary, margin accounts increase your profit potential but much more your risk — loss potential. Additional profit from margin trading is not guaranteed, however what is guaranteed is the commission and the margin interest payment that you have to make to your broker or banker.
Margin debt mushroomed during the bull market of 1999 in the US. While it stood at $5.9 billion in September 1997, it ballooned to a record of $300 billion by March 2000. The factors that drove it this high are the opportunities that investors saw in a bull market, investors’ greed, and excessive marketing by brokers of margin accounts.
During 2000 many margin calls resulted into court cases. This has prompted the National Association of Securities Dealers in the US to announce a ruling requesting all the securities dealers to issue a “Margin Disclosure Statement” to their customers on an annual basis. The following are highlights from the above disclosure statement.
• The firm can sell your securities or other assets without contacting you.
• The firm can increase its “house” maintenance margin requirements at any time and it is not required to provide you advance written notice.
• You are not entitled to an extension of time on a margin call.
(Salim J. Ghalayini, [email protected], is the author of “Stocks for the Practical Investor”. He manages several investment accounts.)
