Chapter 8 Trading on Margin 06 08 2015 Leverage the use of borrowed funds to buy securities Margin of an investor s equity or amount NOT borrowed o An investor makes a 1000 investment of which 750 is his and the remaining 250 is borrowed from the broker 75 margin Margin is the collateral for a broker s loan o Can be cash or acceptable securities stocks bonds mutua funds or derivatives Portfolio a group of financial securities o Value sum of its individual holdings value stock 1 value stock 2 value stock 3 Stock value number of shares x price share Why Trade on Margin Magnifies gains and losses You have 5000 to invest You want shares of stock 50 share o If you don t trade on margin you can buy 100 o If you trade on 50 margin you can buy 200 Buying on Margin Advantage Rules o Magnifies profits o Allows for greater diversification Disadvantages o Maginfies losses o A margin loan is the official vehicle through which the borrowed funds are made available in a margin transaction Have to pay interest o Possible margin calls Must have a margin account with broker o 2000 equity or 100 of purchase price o Lets you borrow from brokerage for investmens o Securities kept by broker until loan is repaid o Lets brokerage safeguard the money it lent to you Margin of investor s equity Minimum Margin Requirement set by Fed the amount of equity that must be the margin investor s own funds about 50 o depends on securities risk o Can vary with the brokerage firm can t be lower than MMR o OTC stocks can t be margined no collateral too risky Example o You want to buy 70 shares at 63 50 Types of Margin o 70 x 63 50 x 0 50 2222 50 so you can then get a loan that matches that the other 50 o However you must pay brokerage fees and interest By raising and lowering the margin requirement the Fed can depress or stimulate activity in the securities markets o Lower margin requirement means more investing because people need less of their own money Initial Margin minimum equity an investor must have in his account at the time of purchase o Prevents overtrading and excessive speculation Maintenance Margin the minimum equity an investor must have in his account at all times lower than IM o Deposit equity margin o Margin equity must be greater than the maintenance margin or you will receive a margin call Margin Call notice that equity in an account is below the maintenance margin 72 hours to improve o Must be returned to maintenance margin OR o Account holdings are sold to bring it back up Restricted Margin Account equity is below initial margin required but higher than the maintenance margin o No more purchases allowed until brought up IM 1000 o Restricted Account MM 500 o Margin Call Facets of Margin Trading Margin Value of Securities Debit Balance o Value of Securities Debit Balance the amount of money being borrowed debt Example Initial Margin 70 able to finance 30 with a margin loan Want to buy 100 shares of stock at 40 share Borrow 0 30 x 4000 1200 Debit Balance 4000 1200 2800 Equity V D Stock moves to 65 share 65 x 100 6500 V Margin 6500 1200 6500 815 81 5 o Margin increased from 70 to 81 5 If stock moves to 30 share 30 x 100 3000 V Margin 3000 1200 3000 60 60 o Margin decreased by 10 Example Joe bought 100 shares of stock at 24 share He used his 70 IM to make the purchase He sold his stock after a year for 20 share Ignoring costs what is the new margin in his account o Value of Securities Equity Debt V E D V shares x price share 2400 100 shares x 24 o Equity 70 x 2400 1680 o Debt 2400 1680 720 stays the same o New Value 100 shares x 20 2000 o E 2000 720 1280 o New Margin V D V 1280 2000 64 o D and of shares purchased remain costant Noteworthy Items Trading on margin has NO impact on stock price direction The lower the amount of the investor s equity in the position the greater the rate of return gain or loss the investor will have when the price of the security rises or falls The more stock shares you hold the greater the dollar return gain or loss It doesn t matter where the money to buy the stock came from Personal funds or borrowed funds The cost of a margin loan depends on current market interest rates and the loan size Return total current income received total interest paid on margin value of securities at sale value of securities at purchase amount of equity at purchase Total Current Income dividends Total Interest Paid on Margin Value of Securities at Sale what YOU paid for them Value of Securities at Purchase what YOU sold them for Amount of Equity at Purchase amount of YOUR put in Example Buy 100 shares at 50 share 5000 Stock pays 2 share in annual dividends current income You hold for 6 months 2 x 100 shares x 6 12 months 100 Buy stock on 50 margin with 10 interest 5000 x 50 2500 equity and 2500 on margin loan Stock moves to 75 share Return 100 125 7500 5000 2500 2475 2500 99 Interest 2500 x 10 x 6 12 125 in six months for 12 months 99 x 2 198 Pyramiding Uses the paper profits in margin accounts to partly or fully finance the acquisition of additional securities Allos investors to make transactions at margins below prevailing initial margin levels How o Paper profits unrealized profits in the account lead to excess margin more equity in the account than required o For example if a margin account holds 6000 worth of securities and has a debit balance of 2000 it s at a margin level of 66 66 6k 2k 6k This would hold a substantial amount of excess margin if the initial margin requirement were only 50 The only constraint and the key to pyramiding is that when the additional securities are purchased your margin account must be at or above the required initial margin level o It is the account not individual transactions that must meet the minimum standards Short Selling 06 08 2015 Long Purchase you buy a stock with the expectation that it s price will rise Buy low hold then sell high Same as a normal buy Long position is when you re holding a stock There s no limit to how high a stock can go but there is a limit to how much you can lose lowest price is 0 Short Selling you borrow stock and you sell it Borrow from brokerage house The broker makes commission every time it s sold No fees unlike margin trading Do it if you think the price is going to go down o Maximum gain is finite lowest price is 0 o No limit …
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