Caution on Margin play
You’re now conversant enough in stock market matters to impress those who are very easily impressed. You’ve learned that each share of stock represents a proportional share of a business and that the potential rewards are great but that stocks are also riskier than putting money in the bank (except missed opportunity as risk!). You’re also aware of the different types of stock (and how each classification is reflected in the ticker symbol), how they are traded on the exchanges, and how to buy them. You even learned a little about options and shorting stocks.
A word of caution at this point: Knowing the terms and general workings of the stock market is just the first step in your investing career. I think that only fools would jump in and start shorting stocks or considering options at this point. Later classes will get back to exploring stocks as to the value of the underlying businesses.
Margin Footnote: Cash vs. Margin.
If you invest in stocks just with the money you have in your brokerage account, you are using a cash account. If you borrow money from the brokerage to invest in stocks, you are using a margin account.
If you borrow money in a margin account to buy stocks, keep in mind that this is not at all “free” money. Your collateral for borrowing the money is the marginable securities in your account, which means they are forfeit if you cannot otherwise repay the margin loan.
You also have to pay a fixed amount of interest on the borrowed money on a monthly basis, which can reduce your overall returns. Because CPF accounts (like IRA accounts in the US) are retirement accounts they are always cash accounts, you cannot use margin in them.
Why Use Margin? Many investors use margin to “juice” up their returns, but fail to appreciate that it can also “squeeze” down their returns. Just as you can make more money than you otherwise would have by using margin, using margin inherently puts you in the Double Jeopardy round—where your running tally can either move up or move down much more quickly than without margin.
The worst-case scenario is when a stock price drops so much that it causes a “margin call,” which means you either add more money to the account or you automatically get sold out of the position at a loss.
What Stocks are Marginable?
In the USA, the Federal Reserve Board currently regulates which stocks are marginable.
As a general rule, stocks selling below US$5 are never marginable and recent initial public offerings are rarely marginable, although it does happen on occasion.
Beyond this, individual brokerages also can decide not to margin certain securities for various reasons. Because of this, your brokerage is always the best source of information for finding out whether or not a security is marginable. In Singapore, the MAS determines what stocks are marginable, and these are noted in financial publications like The Business Times newspaper with a small case “m” just after the 52-week high low, and before the stock listing number and company name columns in the daily stock listing pages (third column).
Initial and Maintenance Margin Requirements:
The amount you can borrow on margin is limited by both the Federal Reserve Board and the individual brokerage you use in the USA. In Singapore, your brokerage may offer different margin accounts, one which strictly adheres to the MAS margin stocks and limits you to 50% debt versus equity, and more liberal accounts at higher interest rates that offer you higher debt levels and more stocks marginable. For instance, the Phillip Securities offers margin financing under a wholly-owned subsidiary finance company known as River Valley, which allows quite high debt to equity ratios on almost all listed stocks, even penny stocks.
Although each brokerage is different, as a general rule 50% of the purchase price of any security can be margin. After you take the position, there is a maintenance margin account requirement that is normally much lower, often around 25%. Check with your brokerage to find out your initial and maintenance margin requirements…and you will be wise to personally make a trip to sit down with your broker to run through some trading scenarios to be crystal clear about your limits so you can safely avoid an evil margin call.
Calculating Buying Power:
After you find out the margin requirements at your brokerage, you can calculate your buying power (again, best you work through this with your broker at your side so there is no confusion). This is how much total stock you can buy given your current cash and marginable securities, including margin. For instance, if you have $3,000 in cash or marginable securities and the initial margin requirement is 50%, you have 6,000 in initial buying power ($3,000 equity + $3,000 margin) = $3,000/$6,000 = 50%). Be very careful when calculating how much buying power you have in your account, as nonmarginable securities do not contribute at all to your buying power.
Margin Call:
Should you fall below the margin requirements, you may be subject to a margin call. If so, you have three days to send in more cash or securities to cover the deficiency or you will be forced to sell out of your positions.
How can you calculate how close you are to the requirement?
If you took the $6,000 position described above using $3,000 in margin and your maintenance margin requirement was 25%, the position could fall as low as a total value of $4,000 before you risked a margin call. ($1,000 equity + $3,000 margin) = $1,000/$4,000 = 25%).
In addition to the margin limits, you broker may also apply borrowing limits to your margin account. For example, if you have $3,000 margin available, but your broker applies a borrowing limit (based on your credit worthiness, like a credit card limit) of $1,000 you cannot exceed the $1,000 borrowing even though you have plenty of margin available.
Using Margin:
Just as the wise investor eschews credit-card debt, she does not believe that the average investor should or needs to be using margin. Although very aggressive, experienced investors could probably margin their accounts up to 20% without incurring a margin call, the fact that your losses are exacerbated should give even the most fearless investor pause. However, because most brokerages will let you short stocks only if you have a margin account-even if you have the cash to cover the short in your account-you may, nonetheless, end up signing that margin agreement and sending it off to the brokerage. Once this is done, however, don’t be in any rush to give that margin a test spin!
Shorting Footnotes:
What is Shorting?
An investor who sells stock short borrows shares from a brokerage house and then sells them to another buyer. Proceeds from the sale go into the short-seller’s account. He must eventually buy those shares back (called covering) at some point and return them to the lender. The short-seller expects that the stock price will go down, so when he buys back the stock to cover, he will pay less for the shares and keep the difference.
Thus, if you sell short 1,000 shares of Madam Wang’s Umbrellas at $2 a share, your account gets credited with $2,000. If the umbrellas start leaking-since the CEO and founder Madam Wang knows more about massages than umbrellas-and the stock begins leaking worse than the umbrellas, tumbling to new lows, then you will start thinking about “covering” your short there for a very nice profit. Here’s the record of transactions if the stock falls to $0.50:
Borrowed and sold short 1,000 shares @ $2.00 = +$2,000.
Bought back and returned 1,000 shares @ $0.50 = -$500.
Profit: = +$1,500.
But what happens if as the stock is falling, Madam Wang’s little sister, umbrella wizard, takes over the business at elder Wang’s request, and the holes and leaks are covered? As the stock begins to take off, from $1 to $2 to $3 to $4, you finally decide that you’d better swallow hard and close out the transaction. You do so, buying back shares at $4 each. Here’s the uglier transaction record:
Borrowed and sold short 1,000 shares @ $2.00 = +$2,000.
Bought back and returned 1,000 shares @ $4.00 = -$4,000.
Loss: = -$2,000.
Ouch! So you see, in the second scenario, you lost $2,000…which you’ll have to come up with. There’s the danger of shorting—you have to be able to buy back the shares you initially borrowed and sold. Whether the price is higher or lower, you’re going to need to buy back the shares at some point.
