Like the flashing lights and sounds of clinking coins at a casino, buying stocks on margin is one of those things that might appear on the surface to be a great way to make money. When things go south, it can get really ugly, really fast, even leading to personal or corporate bankruptcy. Many, many other individuals lost everything when they swung for the fences, some using margin debt, buying more shares than they could afford of a company called GT Advanced Technologies, which went bankrupt.
Entire retirement accounts were wiped out and some investors talked about contemplating suicide. To top it off, if you open a margin account, rather than a so-called cash account, you introduce something called rehypothecation risk. If the financial world ever falls apart, again, which it inevitably will, you might not realize that you've exposed far more of your assets than you knew to losses that aren't even yours.
There is simply no reason to go through life like this. I don't care if it could generate higher fees for the firm. I don't care if a client wants it.
That's not what we do. This might seem to be a bit old-fashioned but there are certain risks that I believe are imprudent. Margin is one of them. With all of that said, if you still aren't deterred about margin, and you want to employ margin debt in your own portfolio, keep reading. In the rest of the article, I'll explain some of the basics of how it works to provide what, I hope, is a better understanding of the mechanics involved.
In the most basic definition, trading on margin is essentially investing with borrowed money. Typically how it works is that your brokerage house borrows money at rock-bottom rates then turns around and lends it to you at slightly higher though still objectively cheap rates, floating you funds to buy more stocks - or whatever other eligible securities you desire - than your cash alone would permit you to buy.
All of the assets in your account, as well as your personal guarantee, are held as assurance that you will repay the debt no matter what happens in the trading account itself. Even if the account blows up, you are on the hook for the money immediately. Meanwhile, as your credit score plummets, you might find everything tied to your credit rating getting destroyed, too. Your insurance rates could skyrocket. Your other lenders could restrict access to borrowing capacity, leaving you no ability to pay your bills.
Utility and phone companies may demand cash security deposits. Potential employers may look at your credit and decide not to hire you. All because you were impatient to make money, not satisfied to compound prudently over time, collecting dividends, interest, and rents along the way. These days, getting access to margin capability couldn't be easier. Brokerage houses make a lot of money both in trade executions and interest income as a result of customers trading on margin.
To open a margin account, all you have to do is indicate you want it on the initial account opening form sometimes, you have to opt out! If you already have an account, all you have to do is fill out a short addendum agreement. The brokerage house may run your credit. Otherwise, eligible individuals, institutions, and other legal entities are given the power to borrow money from within their account.
You can even write checks against your holdings and make withdrawals, the margin debt covering the draft. Each brokerage house establishes a margin maintenance requirement. This maintenance requirement is the percentage equity the investor must keep in his portfolio at all times. Some assets, such as penny stocks, aren't eligible for margin trading at all. Frankly, this is wise. Investing in penny stock is almost always a bad idea , anyway.
Adding leverage on top of it would be deranged. The speculator decides to purchase stock in a company. The lesson is that margin amplifies the performance of a portfolio, for good or ill. It makes losses and gains greater than they would have been if the investment had been on a strict cash-only basis.
The primary risks are market and time. An investor who found an undervalued stock is speculating ipso facto by using margin because he is now betting that the market will not fall far enough to force him to sell his holdings.
It also resulted in the suspension of margin trading for many years. Updated July 30, Margin Maintenance Requirements Each brokerage house establishes a margin maintenance requirement. This is a serious problem. This hour notice is known as a margin call. He would have also had the freedom to ignore the decline in market value if he believed the company was a bargain. The Basics of Trading on Margin When you sign up for a margin brokerage account, generally: All securities in your account are held as collateral for a margin loan, including stocks, bonds, etc.
The margin maintenance requirement varies from broker to broker, stock to stock and portfolio to portfolio. The brokerage firm has the right to change this at any time so you might find yourself with a demand to immediately pay off your margin debt balance with no warning or face having your portfolio liquidated.
If you fail to meet a margin call by depositing additional assets, your broker may sell off some or all of your investments until the required equity ratio is restored. It is possible to lose more money than you invest when using margin. You will be legally responsible for paying any outstanding debt you may have to your broker even if your portfolio is completely wiped out. The interest rate charged by your broker on margin balances is subject to immediate change.More...