Yesterday, we talked about the use of leverage when investing, and how it can amplify your returns, whether positive or negative. In addition, we saw how the interest charged by your brokerage on the borrowed money will lower the returns you make from the borrowed money, regardless of how the investment fares. If I haven’t scared you away from using borrowed money (buying on margin) yet, here’s another concern: the possibility of a margin call.
In brief, when you borrow money in order to buy securities such as stocks, you need to ensure that you own enough of the underlying security to meet the requirements of both the Federal Reserve Board (FRB) and the exchange on which you purchase the security. The FRB sets an opening margin requirement of 50% equity in Regulation T, meaning that would every dollar you pay towards purchasing a security, you can only borrow another dollar. So, if you have $10,000 you want to invest and qualify for a margin account, you can borrow $10,000 from the brokerage to buy the security.
However, once you own the securities, the prices can go up and down, as with any investment. If the price goes up, the percentage of the securities that you own will increase; however, if the prices fall, you will end up owning less than fifty percent of the underlying security (because the amount that you owe to the brokerage will remain the same, meaning only your share amount will rise or fall). Both the New York Stock Exchange and National Association of Securities Dealers set minimum margin requirements of 25%, meaning for every dollar in security equity that you own, you can own up to three dollars of the investment held with borrowed money. (Individual brokers can set stricter requirements, however, so you have to check to ensure you know the rules governing your investments.)
If the value of your securities falls so that your percentage of equity does meet these requirements, you will receive a margin call from the brokerage. At that point, you will need to either invest more money to bring your equity share up to the minimum requirements, or sell the security (at a loss). If our example investment suffered a loss of 40%, dropping to a total value of only $12,000, you would hold 17% equity ($2,000 equity divided by a $12,000 total investment) and would be receiving a margin call. If you couldn’t invest enough new money to bring your stake up to 25% (or your brokerage’s required percentage), you would have to sell the security, pay back the $10,000 and the interest owed, and have less $2000 left of your original $10,000 stake. Some brokerages may even sell your securities automatically, something else you know about your brokerage before you consider using margin.
Besides showing another example of how using margin can amplify your losses, margin calls can also lead you to sell securities that can rise later. If our example stock recovers from its decline and goes on to increase in value, not only will the margin call have caused you to sell your shares for a loss, but you will miss out on the upside. Using borrowed money means that you will need to play by the rules set out by the brokerage, even if they cause you to lose money.
All of this makes using margin rather risky, more so than regular stock investing. What can you do to avoid the threat of getting a margin call? Here’s three possibilities:
1) Don’t Use Margin Investing – The easiest way to avoid a margin call is simply to avoid using borrowed money at all. You will be giving up the upside of using leverage, and will have less money to buy your desired securities, but you won’t have to worry about the whims of your brokerage.
2) Use Less Than the Maximum Margin – You can try to find a middle ground between absolutely no borrowed money and using all the leverage available to you. If you don’t max out the amount of marginal funds you use, you won’t be as vulnerable to falling stock prices. In our example, if you only borrow $5,000 in addition to your $10,000 stake (giving you 67% equity) and the stock price declines by 40%, the total value of the investment will be $9,000 ($4,000 as your equity and $5,000 in borrowed funds). That’s about 44% equity in the fallen investment, more than enough to meet the requirements of the exchanges (although, maybe not your brokerage, if they have a high margin requirement). Having less borrowed money exposes you to less market risk of falling investments.
3) Keep some money set aside in case of margin calls – If you do decide to use the maximum amount of margin possible and your brokerage will allow you to put more money into your investments during a margin call (rather than automatically selling them), you can keep a portion of your money aside in a safe account dedicated for covering margin calls. This allows you to take advantage of the benefits of using leverage through a margin account, but with added insurance in case your stocks decline. (Although, if I had enough money to cover my margin investments, I would just skip using margin investing, invest the money outright and not worry about the rules and complications that come with using borrowed money.)
Any of these methods would allow you to protect yourself from the risks of using margin investing; which one you choose will depend on your own tolerance for risk and investing philosophy.
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