Tips and considerations in using margin
For investors seeking flexibility in managing their portfolio, a margin account can be an invaluable tool. Margin accounts offer convenience, sophistication, and an integrated approach that allows you to fully capitalize on market opportunities. But investing on margin isnt for everybody. It involves elevated risk and is not appropriate for many situations.
The keys to successfully using margin are knowing when and when not to use it, knowing what to use it for, and most importantly, following a disciplined strategy with appropriate checks and limits in place.
How a margin account works
Like buying a house or car with the help of a loan, investing on margin simply means purchasing securities with borrowed funds. To purchase a stock on margin, you first need to have a margin account with a broker.
Depending on the account, different securities may be permitted different levels of margin purchases. For example, you may be allowed to buy up to 75% of one stock on margin, while another may only allow up to 40%.
Margin accounts are typically subject to minimum account balances, which are often based on the loan-to-value ratio of the account (LTV). A margin call occurs when the total loan amount outstanding exceeds the security value of your investment portfolio. A margin call may occur due to a reduction to an LTV held within your investment portfolio. Alternatively, adverse market movements causing a decline in your investment portfolio may trigger a margin call.
To meet a margin call you would need to reduce your loan by depositing funds, provide additional approved investments to increase the security value of your investment portfolio, and/or sell sufficient investments to reduce your overall LTV level. If you do not meet a margin call within the specified time period, your broker may sell sufficient investments held by you to bring your loan back to an acceptable level.
One margin, two scenarios
To illustrate the upside and the downside of margin investing, consider the following example where an investor decides to buy two different stocks on margin. His first purchase, at a 50% margin, is $10,000 of Lucky Corp shares. Luckys share price then climbs 50%, at which point our savvy investor sells and walks away with a 100% profit — double what he would have earned if he had purchased the shares outright. Proceeds of the sale are used in part to pay off the loan, but still leave him with a tidy profit even after trade commissions and interest expense on the loan are factored in.
His second purchase takes a different tack. He purchases $10,000 of Unlucky Corp, again on 50% margin, and the stock price immediately plunges 50%, following an unexpectedly bad earnings report. He liquidates his position, leaving him with a total loss of the $5,000 he invested, using the proceeds to pay off his loan.
The takeaway here is that while margin accounts pose many advantages, they can also be risky and should be used in moderation and with a disciplined strategy in place.
To use margin successfully, it helps to set certain parameters and follow the best-practices of seasoned margin investors:
Use margin for appropriate assets. Your investing goals for a given investment account should dictate whether or not a margin investing strategy is appropriate. A trading account seeking long-term growth that is used for multiple purposes might be the most appropriate, especially if you are an active trader. But you would probably not want to use margin for retirement assets or for accounts that are targeted to fund specific things such as the down payment of a house or a childs education.
Be selective in what you buy on margin. As with any investment, it pays to know what you are investing in before you buy it. This is particularly important in a margin purchase, where a wrong guess can cost much more. Consider companies with strong fundamentals and those in growth industries with an established track record of long-term growth. Using margin accounts for the latest hot stock or to chase momentum stocks is risky.
Keep it short. Investment professionals typically recommend limiting margin purchases to short periods of time. Consider setting one- or two-month windows for margin purchases so that you are not exposed for too long a period to unforeseen price drops or market corrections. And keep in mind that you are paying interest on your borrowed funds, which will lower your net investment return.
Avoid margin calls. A margin call can force you to sell a holding in an inopportune time, locking in losses or missing out on a rally. Worse yet, your broker could liquidate your account for you. To avoid this situation, calculate up front your minimum maintenance requirement — typically 30% of the current value of the account — and make sure it does not go below this limit.
Know when to get out. This holds true on both the winning and losing sides of a trade. If youve purchased a stock on margin that has subsequently had a good run, dont get greedy. Set a target price up front that you hope to reach. If the price surpasses that, reevaluate the fundamentals and consider selling. Likewise, set a limit as to how much of a loss you are willing to take before you sell, and stick to it. One of the most common mistakes investors make is to hold on to a loser too long.
Take a test drive first. The best way to start investing on margin is to try it out with one or several securities first. This will give you an opportunity to experience the benefits as well as the costs and risks of margin investing on a small scale first. It will also allow you to establish a disciplined margin strategy before you apply it to larger investments.
A margin strategy executed prudently can be a valuable tool. But you have to be disciplined, know what youre doing, and accept a high amount of risk.
Before trading stocks in a margin account, you should carefully review the margin agreement provided by your firm. It is important that you fully understand the risks involved in trading securities on margin. These risks include the following:
- You can lose more funds than you deposit in the margin account. A decline in the value of securities that are purchased on margin may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securities or assets in your account(s).
- The firm can force the sale of securities or other assets in your account(s). If the equity in your account falls below the maintenance margin requirements or the firms higher house requirements, the firm can sell the securities or other assets in any of your accounts held at the firm to cover the margin deficiency. You also will be responsible for any shortfall in the account after such a sale.
- The firm can sell your securities or other assets without contacting you. Most firms will attempt to notify their customers of margin calls, but they are not required to do so. However, even if a firm has contacted a customer and provided a specific date by which the customer can meet a margin call, the firm can still take necessary steps to protect its financial interests, including immediately selling the securities without notice to the customer.
- You are not entitled to choose which securities or other assets in your account(s) are liquidated or sold to meet a margin call. Because the securities are collateral for the margin loan, the firm has the right to decide which security to sell in order to protect its interests.
- The firm can increase its house maintenance margin requirements at any time and is not required to provide you advance written notice. These changes in firm policy often take effect immediately and may result in the issuance of a maintenance margin call. Your failure to satisfy the call may cause the firm to liquidate or sell securities in your account(s).
- You are not entitled to an extension of time on a margin call. While an extension of time to meet margin requirements may be available to customers under certain conditions, a customer does not have a right to the extension.
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