Please Pass the Margin

Moving Day. iStock by Getty Images.

Some people prefer butter. Some people prefer margarine. Some people prefer olive oil, and some people don’t use any of the above.

At a restaurant, you might say “please pass the butter” or “please pass the olive oil” but you probably never say “please pass the margarine”.

I am not intentionally confusing margarine with margin. I want to get your attention.

For those of you opening a brokerage account, you will be asked if you want to “trade on margin”.

If you don’t know what margin is, then you should check the “no” box. If a few years from now you become a seasoned investor you can always add margin to your account.

Financial margin means borrowing money. Brokerage firms will lend you money. But it is never as simple as it seems.

Anytime you borrow money there is always a due date. Credit cards, student loans, mortgages, utilities require you to “pay this amount by this date”.

Not paying is not an option except under certain circumstances, like a global pandemic,  when some payments can be negotiated.

Not the case if you borrow money from a brokerage firm and trade on margin. 

Why would you borrow money from a brokerage firm? 

Investors borrow money from a brokerage firm to buy more securities like stocks and bonds. 

I want to own 200 shares of a certain stock .

I have enough money to buy 100 shares.

I pay for 100 shares and borrow the money to buy another 100 shares.

If the stock price goes up, I have doubled my return.

If stock prices go down, I could be in for a world of hurt because my losses have doubled.

When I trade on margin there is a specific limit on how far the price of the stock can go down before I must pay back the loan.

The difference between borrowing from a brokerage  and using a credit card is time. 

Margin accounts are regulated. The condition regulators impose is that I pay back the loan by the end of the trading day if the price of the stock drops below a certain level.

Yikes! 

Buying stocks on margin is also known as leverage. 

An example of leverage is buying a home and having a mortgage. If I don’t have enough cash on hand to pay for a house in full, I borrow the money to pay for it. 

If my income is $100,000.00 a year and I borrow $500,000.00 to buy a house, I am 5 times leveraged. 

Or I can think of it this way:

The value of my asset (my income) is $100,000.00 and my debt is $500,000.00. I owe 5 times more than I make.

Back to the margin account.

Stock prices fluctuate constantly. If I borrow money to buy stock, an asset, and the value of the stock goes down, my asset is worth less than the amount I borrowed. That is when the brokerage firm comes calling.

If I can’t pay the margin loan upon demand, the brokerage firm has the right to immediately liquidate any or all the securities in my portfolio to pay back the loan. The brokerage firm can,  without telling me, decide which securities to sell.

If I have been in love with a couple of great performing stocks, and I have borrowed in a margin account, those stocks could disappear from my portfolio in a heartbeat, or a day. And I have no recourse. 

Margin accounts are ruthless. They are unforgiving. They do not care about my feelings and they give me no leeway if I owe money. The terms are set and there is no negotiating.

If you decide to open a margin account, be prepared to watch your account like a hawk all day long. 

If the market is volatile and shares go up you could be a big winner. If prices go down you could be a bigger loser. If you are not paying attention you may be too late to trade out of a stock before the margin regulators catch you.

So why would anyone want a margin account?

There are investors , both individual and institutional investors, who do watch the markets all day long and are prepared to act. They have the experience and knowledge to leverage their portfolios.

The reason to leverage a portfolio is to increase returns. If I am a portfolio manager for a mutual fund, I am competing with many other investment managers . I want to outperform other managers and the stock market. 

For the rest of us, Schwab, for example, recommends a minimum of 5 years investing experience before opening a margin account.

That begs the question : How many inexperienced investors opened margin accounts in 2020?

More to the point, if they were inexperienced why would a brokerage firm lend them money ?

Investing 2020: New Accounts and the People Who Opened Them (finrafoundation.org)

An excerpt from the study noted the following:

“Margin trading.

 Margin allows investors to borrow money from a brokerage firm to buy stock. Buying on margin exposes investors to the potential for greater losses as well as greater gains. While only 29 percent of investors indicated they had an account that allowed them to make purchases on margin, almost half (48 percent) of investors did not know if their investment account allowed purchasing on margin. The majority (55 percent) of New Investors and a plurality of Experienced Entrants (40 percent) and Holdover Account Owners (46 percent) did not know whether their investment account allowed them to make purchases on margin. Of those who reported having a margin account, only about onequarter (23 percent) reported actually using margin to purchase investments; this equates to 6 percent of respondents.”

For now, pass on the margin account please.

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.