Sunday, November 23, 2008

Stocks: Understanding the use of margins

Buying stock on margin is a way of leveraging your available investment cash to buy more stock than cash alone would buy. The hope is that the stock price will continue going up so the investor gains from appreciation of additional stocks purchased on margin than the lessor amount would have bought with cash alone. This can be great when the stock price goes up. However, when the price goes down, margined stock will work very quickly against you. We’ll cover more about buying stock on margin, along with the pros and cons.

Buying stock on margin
For qualified investors, many brokers offer the option of buying stock “on margin” by borrowing funds from the broker to pay for part of the purchase. Not all stocks are marginable and those that are maginable vary in the amount of margin authorized. Typically these stocks have a 50% margin requirement, which means you only need 50% of the stock price in cash to buy a share of stock. Another way of thinking about this is to say you can buy twice the number of stock shares than cash alone could buy. Some highly risky stocks have a higher margin requirement, meaning a higher percentage of cash is required to purchase a share of stock. In any case, a monthly interest will be charged for all borrowed funds until these funds are paid back.

Consider an example of buying stock on margin
For all examples, the cost of trading stock will be ignored. For this example, Joe investor has $1,000 cash available to buy stock in XYZ corporation. Shares of XYZ stock are trading at $10 per share. In this case, Joe can buy 100 shares of XYZ stock for his $1,000 ($10 per share x 100 shares = $1,000). Now assume that XYZ stock is a marginable stock with a 50% margin requirement. This means each $10 share of stock can be purchased with $5 in cash and the other $5 borrowed from the broker ($5 cash + $5 borrowed = $10 purchase price of a share). Now Joe only needs $500 for the same 100 shares since he borrows the other $500 from the broker to make up the full $1,000 needed to purchase the 100 shares. Alternatively, Joe could use his full $1,000 cash to buy twice the number of shares on margin. In this case, 200 shares at $10 requires $2,000 for the purchase. Joe uses $1,000 of his cash and borrows the other $1,000 for the margin purchase. In both cases, Joe has used leverage to control twice the number of shares that cash alone would purchase.

Why use margin?
As we’ve seen, buying stock on margin allows you to use less cash to purchase stock. If an investor determines there is a strong possibility the stock price will go up, the investor can chose to buy twice the number of shares (for 50% marginable stock) for the same amount of money. The investor then benefits from price increases on twice the number of shares. However, there is now a higher risk of loss if the share price should go in the opposite direction.

An example of margin leverage working in the investor’s favor
Continuing the previous example, Joe purchases 200 shares of XYZ stock (a 50% margin requirement stock) for $1,000 cash. The stock goes from $10 to $15 per share, a 50% price increase. Joe now has $5 profit in 200 shares of stock for a total profit of $1,000. Joe has a $1,000 gain on his original $1,000 cash, a 100% increase. Joe has doubled his money from a 50% increase in stock price. Leveraging with margin has allowed him to have twice the percentage of return than the stock price increased by.

Alternatively, if Joe had used his $1,000 cash to buy only 100 shares without margin, then he would have a $5 profit on 100 shares for a total profit of $500. He then has a $500 gain on his original $1,000 cash, a 50% increase. His investments have increased the same percentage as the stock price increased.

What can go wrong?
The danger in using margin is you now have a much higher risk exposure to loss than using cash. If the stock price drops with stocks purchased on margin, your loss will increase at a much faster rate. At some point, the broker will issue a “margin call” when the value of the stock goes down enough to require you to put additional money into your account to bring the percentage of cash back to 50%, or whatever margin level your stock is at. Lets look at an example.

An example of margin leverage working against the investor
Continuing the previous example, Joe bought 200 shares of XYZ stock with 50% margin for $1,000. Remember that Joe used $1,000 cash and borrowed $1,000 on margin for the $2,000 purchase of 200 shares at $10. Therefore, he is at 50% margin. Now assume the price goes from $10 per share to $8 per share. In this case, the total value of the stock is now $8 x 200 or $1,600. Joe still owes $1,000 against this $1,600 total value so he would only get $600 cash by selling all of the stock today. This means his margin level or ratio of cash to the total value is now at a 37.5% ($600 cash remaining divided by $1,600 current value = 37.5%). Typically a broker will ask for more cash when the ratio gets to 30% to bring the ratio back to 50%.

Notice that the $1,000 owed does not change, but the portion of cash remaining decreases as the price decreases. Now consider what happens if the price quickly drops by 50% from $10 to $5 per share. The total value of the 200 shares is $5 x 200 or $1,000, which is the same as the $1,000 still owed. Now there is no cash left since the sale of all 200 shares would go directly toward paying off the $1,000 debt (assuming interest owed is ignored). Joe has just wiped out all of his investment cash. He will be asked to put in another $1,000 to bring the margin level back to 50% ($1,000 cash and $1,000 debt) or be forced to sell some or all of the stock until enough of the debt is paid back to bring the ratio back to 50% (perhaps sell 100 shares at $5 to pay off $500 of the $1,000 debt).

Consider an even more severe case where the price drops quickly to zero (perhaps the company goes bankrupt and all stock shares are wiped out by bankruptcy). In this case, the investor lost all of the initial $1,000 investment funds and now owes $1,000 borrowed on margin for a total $2,000 loss. Had Joe purchased only 100 shares with cash, he would only be out the $1,000. Using margin two buy twice the stock also caused him to have double the loss.
In any case, you can see that rapid drops in price can really work against the investor who uses margin.

Personally, I only use margin for a few situations:
1. I might use margin when all my technical analysis of the recent stock buying and selling patterns (trends, volume, stochastics, MACD, and other indicators) indicate a strong probability of price increase in the very near future. I’ll buy twice the stock for the same investment funds to hopefully catch the increase and then either sell enough stock to pay off the margin and keep the rest or I’ll sell out before the stock drops again.
2. I might use margin against a stock already in my portfolio (borrow money against a stock I have) to purchase another stock or option. Again, I want to do this on short term moves to quickly pay off the debt.
3. I need to have enough cash or assets in my account to short a stock. Brokers usually require assets in an account before letting you short stock. See a previous article on shorting stock.
4. When I need a short term loan for other personal uses. Say I need $1,000 for car repairs. If there is marginable stock in my account, I could borrow the $1,000 against these stocks to pay for the repair. Then I’ll pay the debt off as soon as possible.

The use of margin is another tool that can help an investor manage his or her investment portfolio. However, recently we’ve seen articles about top managers of companies being forced to sell their shares of stocks due to margin calls (Wall Street Journal aticle on top managers losing shares to margin, New York Times article on Chesapeake CEO being forced to sell all of his shares of the company, and many others).

Using margin smartly can help increase returns, but the investor must be very careful since it can also magnify losses very quickly.

Copyright 2008 Ole Cram, President of Marcobe Investments, Inc.
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