In the previous section, we discussed the two restrictions imposed on the amount you can borrow. First, the initial margin, which is the initial amount you can borrow. Second, the maintenance margin, which is the amount you need to maintain after you trade.
Our focus in this section is the maintenance margin. In volatile markets, prices can fall very quickly. If the equity (value of securities minus what you owe the brokerage) in your account falls below the maintenance margin, the brokerage will issue a “margin call”. A margin call forces the investor to either liquidate his/her position in the stock or add more cash to the account.
Here’s how it works. Let’s say you purchase Rs.20,000 worth of securities by borrowing Rs.10,000 from your brokerage and paying Rs.10,000 yourself. If the market value of the securities drops to Rs.15, 000, the equity in your account falls to Rs5,000 (Rs.15,000 – Rs.10,000 = Rs.5,000). Assuming a maintenance requirement of 25 percent, you must have Rs.3,750 in equity in your account (25 percent of Rs.15,000 = Rs.3,750). Thus, you’re fine in this situation as the Rs.5,000 worth of equity in your account is greater than the maintenance margin of Rs.3,750. But let’s assume the maintenance requirement of your brokerage is 40 percent instead of 25 percent. In this case, your equity of Rs.5,000 is less than the maintenance margin of Rs.6,000 (40 percent of Rs.15,000 = Rs.6,000). As a result, the brokerage may issue you a margin call.
If for any reason you do not meet a margin call, the stock broker firm has the right to sell your securities to increase your account equity until you are above the maintenance margin. Even scarier is the fact that your broker may not be required to consult you before selling! Under most margin agreements, a firm can sell your securities without waiting for you to meet the margin call. You can’t even control which stock is sold to cover the margin call. Because of this, it is imperative that you read your margin agreement very carefully before investing. This agreement explains the terms and conditions of the margin account, including: how interest is calculated, your responsibilities for repaying the loan and how the securities you purchase serve as collateral for the loan.
Margin trading: Advantages
Why use margin? It’s all about leverage. Just as companies borrow money to invest in projects, investors can borrow money and leverage the cash they invest. Leverage amplifies every point that a stock goes up. If you pick the right investment, margin can dramatically increase your profit.
It’s easy to see how you could make significantly more money by using a margin account than by trading from a pure cash position. What really matters is whether your stock rises or not. The investing world will always debate whether it’s possible to consistently pick winning stocks. We won’t weigh in on that debate here, but simply say that margin does offer the opportunity to amplify your returns.
The best way to demonstrate the power of leverage is with an example. Let’s imagine a situation that we’d all love to be in - one that results in hugely exaggerated profits:
We’ll keep with the numbers of Rs.20,000 worth of securities bought using Rs.10,000 of margin and Rs10,000 of cash. If company A is trading at Rs100 and you feel that it will rise dramatically normally, you’d only be able to buy 100 shares (100 x Rs100 = Rs.10,000). Since you’re investing on margin, you have the ability to buy 200 shares (200 x Rs100 = Rs.20,000).
Company A then locks in a famous cricketer as a spokeswoman and the price of shares skyrockets 25 percent. Your investment is now worth Rs.25,000 (200 shares x Rs125) and you decide to cash out. After paying back your broker the Rs.10,000 you originally borrowed, you get Rs.15,000 out of which Rs.5,000 is profit. That’s a 50 percent return even though the stock only went up 25 percent. Keep in mind that to simplify this transaction, we didn’t take into account commissions and interest. Otherwise, these costs would be deducted from your profit.
Margin trading: Risks
It should be clear by now that margin accounts are risky and not for all investors. Leverage is a double- edged sword, amplifying losses and gains to the same degree. In fact, one of the definitions of risk is the degree that an asset swings in price. Because leverage amplifies these swings then, by definition, it increases the risk of your portfolio.
Returning to our example of exaggerated profits, instead of rocketing up 25 percent, if shares fell 25 percent your investment would be worth Rs.15,000 (200 shares x Rs.75). You sell the stock, pay back your broker the Rs.10,000, and end up with Rs.5,000. That’s a 50 percent loss, plus commissions and interest, which otherwise would have been a loss of only 25 percent.
Think a 50 percent loss is bad? It can get much worse. Buying on margin is the only stock-based investment where you stand to lose more money than you invested. A dive of 50 percent or more will cause you to lose more than 100 percent, with interest and commissions on top of that.
In a cash account, there is always a chance that the stock will rebound. If the fundamentals of a company don’t change, you may want to hold on for the recovery. And, if it’s any consolation, your losses are paper losses until you sell. But as you’ll recall, in a margin account your broker can sell off your securities if the stock price dives. This means that your losses are locked in and you won’t be able to participate in any future rebounds that may take place.
If you are new to investing, we strongly recommend that you stay away from margin. Even if you feel ready for margin trading, invest with your risk capital - that is, money you can afford to lose.