INVESTING ON STEROIDS.That's what margin trading is all about. Borrow some money, add it to your own, put it on a growth stock and...presto!...double your profits, double your fun.
Unless, of course, the stock goes down. Then you find yourself doubled over in pain - just like the first time you crapped out in Vegas.
Margin trading isn't gambling, but it can sure seem that way. But don't worry: If what you're expecting now is conversation on the evils of margin investing, we'll spare you a sermon. The goal here is to educate you, not scare you. The fact is, a margin strategy put down correctly can pay off big. But you have to know what you're doing and accept a huge amount of risk. What follows is an introduction to get you started.
What Is Margin Trading?
Think of margin as a loan from your broker. It allows you to purchase more shares of a stock than you'd be able to with what you have stashed away in your own bank account. When you open a margin account (it doesn't matter whether you trade online or offline) your broker will ask you to sign a contract called a margin agreement. Usually, you'll be required to make an initial investment of at least $2,000 (though some brokerage firms require higher minimum investments). And once you've opened the account, you can then borrow up to 50% of the purchase price of a stock, so long as you have enough money in your account to cover the balance.
Here's an example. Let's say you want to buy $20,000 worth of Microsoft (MSFT) stock, 50% of it on margin. That means you need to have at least $10,000 cash in your account, allowing you to borrow the other $10,000. Just like a bank, your broker will charge you interest on the loan. Rates vary between firms and can depend on the balance in your account as well as the current interest rate environment. At the end of September 2001, for instance, E*Trade was charging 8.0% on a $50,000 margin account.
You can usually keep the loan out as long as you want -- with a couple of provisions. First, when you finally sell the shares of stock in your margin account, you'll have to immediately pay back the money you borrowed plus interest and any trading commissions. (You keep the remaining profits.) Second, if the value of your portfolio falls below a certain threshold, the brokerage reserves the right to "call" the loan, meaning you have to pay back what you borrowed whether you want to or not. This ominous event is referred to as a "margin call." We'll talk more about that below.
For now, though, let's focus on the fun part -- exaggerated profits. Imagine that Microsoft one day finally settles, once and for all, its massive antitrust case. And let's say that overnight, the $20,000 in stock you bought jumps 30% to $26,000 and you're feeling flush. If you decided to sell those shares and book profits, you'd be sitting on $16,000 in returns. You'd owe the brokerage the $10,000 (plus fees and interest) you borrowed, but you'd get to keep the extra $6,000. That's double the $3,000 profit you would have earned had you bought just $10,000 worth of Microsoft stock. And instead of a 30% return on your investment, you'd book a 60% return. See what we mean? Investing on steroids.
The Grim Reaper
Now you know why buying stocks with borrowed money has become so popular. You juice your profits and your broker earns interest. When the market is rising, buying on margin is a win-win scenario for investors and brokers alike. But what about when the market is falling? Does that mean you lose money twice as fast?
Yep.
Let's say, for example, that Microsoft's stock plunges 30% in a day. Your $20,000 stake dwindles to about $14,000 in the blink of an eye. If you were to sell those shares, you would be forced to pay back the $10,000 loan (plus interest and fees), leaving you with just $4,000. Had you invested $10,000 only (and avoided the margin loan) that 30% loss would have let you walk away with $7,000. Not good, but not devastating, either.
It gets worse -- much worse. With a normal investment gone sour you can at least take comfort in the notion (however thin) that your losses are paper losses, at least until you sell the stock. Maybe your $10,000 has become $7,000, but so what? If you wait long enough, Microsoft stock is likely to recover and you'll be back in business.
With margin investing, though, you may not have that choice. As we mentioned above, your brokerage reserves the right to "call" your loan if the value of your equity falls below a certain threshold of the account's total value. The minimum maintenance requirement established by the New York Stock Exchange for its member firms is 25% of the current value of the account. But most brokerages use a higher number - maybe 30% -- and it can go even higher than that if you buy some very volatile stocks like Yahoo! (YHOO) and Amazon.com (AMZN).
In the above example, that means you have to sell your shares and pay back your brokerage immediately. Here's why: Say your firm's margin requirement is 30%. That means your equity in the margin account (the account's market value less whatever you owe on your loan) must be 30% of the account's current value. When that Microsoft stock fell 30%, your total account fell to $14,000 and your equity (measured as $14,000 minus the $10,000 you owe) dropped to $4,000. Since that $4,000 is just 28% of the $14,000, you would be subject to a margin call, meaning you have to either liquidate your account to pay off the loan or put up more money to satisfy the margin requirement.
But beware -- when the markets are tumbling quickly, you may not get a margin call at all. Your broker might just liquidate your account for you. Most margin agreements give brokers the right to sell off a customer's margin account without notice if such a move is necessary to protect the broker's capital. In fact, that's what happened quite frequently during the big tech sell-off in April 2000. Many brokerage firms like TD Waterhouse didn't wait the customary three-day period for investors to deposit additional money into their accounts. Instead the firms liquidated accounts without warning.
More Than 100%?
The worst-case scenario (and not a rare one) is when you lose more than 100% of your original equity. Let's say you bought $34,000 worth of Gap (GPS), back in May 2001, thinking it had finally figured out how to stem its declining sales. The stock was trading at $34 in late May, and at the time, few people would admit that the nation was in a recession.
Unfortunately, the recession had indeed begun, and that meant consumers were holding onto their wallets more tightly. Worse for you, Gap's sales continued to decline. The stock fell 55% to $15 in the beginning of September. Things would have been bad for you if you had bought the shares outright, but you would have been in even worse shape if you bought half using $17,000 cash and used a $17,000 margin loan with 8% interest to buy the rest. In stead of just being left with $16,000 worth of stock, you'd have to sell the rest of your shares and pony up another $1,340 just to cover the $17,000 you borrowed plus the interest the loan accrued.
"It is the one investment you can make where you can lose more than 100% of your principal," says Joe Grunfeld, a financial consultant with Merrill Lynch.
Crafting a Strategy
So if margin investing is so perilous, should average investors simply avoid it altogether? Not necessarily. But as with any investment, you have to know what you're getting into and whether you can afford it -- both financially and psychologically.
Steve Kaye, a financial planner with New Jersey-based American Economic Planning Group says an investor who buys stock on margin must always be mindful of the downside risk, even when the markets seem to be heading straight north. You have to be able to "withstand a worst-case scenario,'' which means you can afford to lose everything and then some. He suggests that you calculate exactly how much you stand to lose before making any investment. Then you should keep some cash on the side to cover any potential deficiency. (Sounds pretty much like the old casino strategy: putting $200 in your pocket and playing until the sun comes up or your money's gone.)
It goes without saying that you should never put money you need for anything from retirement to the down payment on your house in the account. Restrict yourself to "risk capital," or money you can afford to lose.
And don't chase momentum with a margin account. Going after Wall Street's darling stocks that are hitting all-time highs is always risky. But it's doubly so on margin. More often than not, the price will come down, or it won't go much higher, and you'll end up owing more money to the brokerage firm. That, of course, isn't always true, but betting on momentum is a gamble. Just ask anyone who bought into the biotech firm ImClone Systems in spring 2001.
It's really no different than regular investing - the better policy is to use margin to buy stocks that look like values. And don't get greedy. Many experts suggest using margin for short-term trading, after which you cash-in a position when the stock rises. Using margin in this way also limits the amount of interest you will pay on a loan. "Margin is useful in trading, trying to capture short-term moves in the market," Merrill Lynch's Grunfeld says.
The key is to remember that margin is a tool -- not a winning lottery ticket. In good times, it can help you make a little more money and buy some of those stocks you've been eyeing for a while. But in bad times, it can cost you a bundle. The bottom line is simple -- know the risk and don't get sloppy. If you don't know what you're doing, you're playing with fire.
