This illustrates the risks of using margin: you may be forced to sell at the very time when stock prices hit bottom! And since other investors will also be forced to sell in the declining market, the market declines even further. When the stock market starts declining, it is best to sell some stock to lock in gains and to pay off margin; otherwise you will be forced to sell low after you bought high.
100 Leverage Ratio
Example — Calculating the Margin Percentage from the Leverage Ratio
A 100 :1 leverage ratio yields a margin percentage of 100/ 100 = 1%. A 200 :1 ratio yields 100/ 200 = 0.5%. You’ll often see these leverage ratios advertised by forex brokers. A 100:1 ratio allows you to buy $100,000 worth of currency while posting only a mere $1,000! Forex brokers can offer these low margin requirements because currency doesn’t move with the same magnitude as stocks, especially in a short time, but the large leverage ratio does make currency trading very risky if all the margin is used.
Leverage Ratio = 1/Margin Percentage = 100/Margin Percentage
Example — Calculating the Leverage Ratio from the Margin Percentage
Most stock brokers require at least a 50% initial margin , therefore:
Leverage Ratio = 1 / 0.5 = 2
In other words, you can buy twice as many stocks using maximum margin than you can without using margin. Your investment is leveraged for greater profits or greater losses.
Margin ratios are usually much smaller in futures than for stocks, where leverage ratios are typically 10:1, which is equal to a 10% initial margin requirement, but this varies depending on the underlying asset, and whether the trader is a hedger or a speculator—speculators have a slightly higher margin requirement. Forex accounts have an even lower margin requirement, which may vary, depending on the broker. Regular forex accounts typically allow 100:1 ratios, which corresponds to a 1% margin requirement, and the typical ratio for a forex mini-account is 200:1.
The rest of this article will discuss using margin for buying or shorting stocks. More information about using margin in futures and for forex can be found here:
Margin Agreement, Initial Margin, Maintenance Margin, Margin Calls, and Restricted Accounts
The most general definition of margin, one that covers both buying and shorting securities, is the ratio of the equity of the account divided by the value of the securities. The equity of the account is simply what is left when the debit balance is paid in full or the shorted stocks have been bought back and returned to the lender.
If money is borrowed, then it must be paid back, so the amount borrowed plus the accrued margin interest is a debit to the account; if stocks are sold short, then the shorted stocks must be bought back, so the value of the shorted stocks are a debit to the account.
Equity Value of Securities
The main reason to borrow money to buy securities is for financial leverage. Financial leverage can increase the rate of return for an investment, if it is profitable, but it also increases potential losses. Because of the potential for greater losses, traders become more emotional in their trading decisions, which may cause excessive trading, which increases transaction costs, and it may cause bad trades when emotion overrules reason. Furthermore, the longer the money is borrowed, the greater the amount of margin interest that must be paid, so using margin for buy-and-hold strategies is generally not a good idea.
Another major disadvantage to using margin is that the trader potentially loses some control over the account. If purchased stock drops too much, the broker has the right to sell the stock before notifying the customer. For a short sale, the broker may be forced to buy back the securities in an illiquid market, if the lender wants the securities back.
If the margin ratio increases because purchased securities have increased in value or because shorted securities have decreased in value, then the trader gains excess margin that can be used to purchase or short additional securities. Continually using excess margin to increase investments is called pyramiding. While pyramiding may work for a while, at some point, the equity of the account is going to decline, because stocks don’t continually increase in value nor do shorted stocks continually decline in value. Therefore, eventually there will be a margin call. Hence, the use of margin should be restricted to short-term trades.
In a long transaction, you borrow money to buy securities, which you are obligated to pay back. Similarly, in a short sale, you sell securities short by borrowing the securities from a broker, then selling them, with the proceeds deposited in your account. But eventually you’ll have to buy the securities back to return them to the lending broker, which is why the market value of the shorted securities is considered a debit to your account.
Equity is equal to the total value of cash and securities if all open positions are closed and all financial obligations are satisfied. So if you deposit $5,000 in an account, and borrow $5,000 to buy $10,000 worth of stock, then your equity is initially $5,000 minus transaction costs. Accruing margin interest will also decrease your equity. If the value of the stock declines to $8,000, then your equity is reduced to $3,000 minus costs, because now the stock is worth $8,000, but you are still obligated to pay your broker $5,000 plus interest for the loan, which is your debit balance. Hence, when using margin to borrow money to enter into a long position by buying stocks:
Equity = Account Value – Debit Balance
Equity Value of Securities
Example — Calculating the Equity of a Short Account
If you deposit $5,000 and sell 1,000 shares of XYZ stock short for $10 per share , then there is $15,000 on deposit in your account, but your equity is still $15,000 – $10,000 = $5,000 , which is, of course, what you initially deposited.
If XYZ price rises to $12 per share , then your equity = $15,000 – $12,000 = $3,000 .
If XYZ price drops to $8 per share , then your equity = $15,000 – $8,000 = $7,000 .
Equity Value of Shorted Securities
Example—Calculating the Current Margin and Current Equity of a Short Sale.
You open a margin account and deposit $5,000 . You sell short 1,000 shares XYZ stock for $10 per share . The proceeds of the sale, $10,000 , is deposited in your account for a total account value of $15,000 .
Scenario 1 — The stock price declines to $6 per share , so the 1,000 shares that you sold short is currently worth $6,000 . Thus:
Calculating Margin Call Account Values
The margin maintenance requirement requires that the margin ratio always be greater than the margin maintenance requirement. If the margin ratio drops below this, then a margin call will be issued. At what account value will a margin call be issued?
First, we consider the use of margin for buying securities. We can derive this formula from the formula for calculating the margin.
Example – Finding the Account Value That Will Elicit a Margin Call
You deposit $5,000 and borrow $5,000 to buy $10,000 worth of securities . If the maintenance margin requirement is 30% , what is the value of the securities that will cause a margin call to be issued?
call will be issued if the value of the securities drops below $7,142.86 . To verify the answer, we’ll plug this account value into the margin formula to see if it comes out to the maintenance margin percentage:
Margin = ( $7,142.86 – $5,000 ) / $7,142.86 = $2,142.86 / $7,142.86 = 0.30 = 30%
Now we determine the formula for calculating the value of securities that will elicit a margin call for shorted stock, which is a slightly different equation:
Example — Calculating the Margin Call Price of a Shorted Security
You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share . The proceeds of the sale, $10,000 , is deposited in your account for a total account value of $15,000 . The margin maintenance requirement is 30% . Therefore, the margin call value = 15,000 /(1 + .3 ) = 15,000 / 1.3 = $11,538.46 . This is equal to a price per share of $11,538 / 1,000 = $11.54 (rounded) per share. So a margin call will be triggered when the price of the shorted security rises to $11.54 .
To verify, we substitute $11,538.46 into the margin formula for shorted stock, and find that ( 15,000 – 11,538.46 )/ 11,538.46 = 0.30 = 30% , the margin maintenance requirement. Note that if any dividends were paid out, this would have to be subtracted from the account value.
Return on Investment
Margin increases the rate of return on investment, if the investment is profitable, but increases losses, if not. Furthermore, transaction costs, margin interest, and any dividend payments for shorted stock subtract from profits but add to losses. Any dividends received from purchased stock will increase profits and reduce losses. For a purchase, the rate of return is determined by the following equation:
Rate of Return for a Long Position Formula
For instance, if you purchased $10,000 worth of stock with cash and the stock rises to $12,000 , then your return on investment is:
Rate of Return = ( $12,000 + 0 – $10,000 – 0 ) / $10,000 = $2,000 / $10,000 = 20%
If instead of paying cash for the stock, you pay $5,000 cash and use $5,000 of margin , then your rate of return, ignoring margin interest to simplify things:
Rate of Return = $2,000 / $5,000 = 40%
As you can see, using the maximum amount of margin almost doubles your rate of return if the holding period is short enough to keep margin interest negligible. From this example, you can also clearly see that if the value of the stock decreased by $2,000 instead of rising, then there would be minus signs in front of the rates of return. Furthermore, margin interest increases potential losses and subtracts from potential profits. To illustrate, if your broker charges 6% annual margin interest and you hold the stock for 1 year, then your broker will charge $300 of interest for the $5,000 you borrowed for 1 year. Thus, the rate of return if stock is sold for $12,000 is:
Rate of Return = ( $12,000 – $10,000 – $300 ) / $5,000 = $1,700 / $5,000 = 34%
If the stock is sold at a loss for $8,000 :
Rate of Return = ( $8,000 – $10,000 – $300 ) / $5,000 = -$2,300 / $5,000 = -46%.
The longer the margin is borrowed, the more margin interest will decrease any potential profits and increase potential losses.
Note that the equation for shorted stock would be slightly different, since, as a short seller, you must pay any dividends to the lender of the stock that the lender would have otherwise received, but you do not have to pay margin interest. However, you do have to post an initial margin requirement, which is typically equal to ½ of the value of the shorted stock. Thus, the equation for the rate of return for the short seller is:
Long Rate of Return
Stock Sale Price
+ Dividends Received
– Stock Purchase Price
– Margin Interest Stock Purchase Price
Rate of Return for a Short Sale Formula
Short Rate of Return
Stock Sale Price
– Dividends Paid
– Stock Purchase Price Initial Margin Requirement
Using margin is risky. Sometimes stock prices drop so fast, there is no time for margin calls, so the broker is forced to sell margined stock at low prices, potentially devaluing an account to zero or even less! A good example is provided by the credit crisis of 2008. During the week ending October 13, 2008, the average stock price plunged 18%, forcing many investors who bought stock on margin to sell, which was probably a major factor contributing to the steep decline. Consider these examples reported in this New York Times article, Margin Calls Prompt Sales, and Drive Shares Even Lower:
Stocks in Margin Accounts Can Lead to Empty Voting and Payment in Lieu of Dividends
There are 2 disadvantages to holding stocks in a margin account, which are often lent out to short sellers:
stock borrowers, but not stockholders, can vote shares when the shares are lent out, which leads to what is being called empty voting;
and if the stocks pay a dividend, the stockholders actually get — instead of a dividend that may qualify for the favorable tax rate of 0%, 15%, or 20% — a payment in lieu of dividends, which is taxed as ordinary income that may be as high as 37%. See Taxation of Dividends for more information.
Worse, the borrowers of the stock, often short-sellers, can vote against the corporation’s interest to put downward pressure on the stock price, so as to increase short-selling profits — thus, voting against the interests of the true stock owners.
A possible scenario is for a hedge fund, which frequently profits from short selling, to borrow the shares right before the record date—usually 30 days before the vote, and vote in its own interests. Delaware law, which governs most large companies because they are incorporated in that state, gives voting rights to whomever happens to have the stock on the record date. Often, the beneficial owners of the stock are unaware of the lending, and that their right to vote has been transferred to someone else.
Sometimes, because of inadequate accounting, both actual stockholders and the borrowers vote, leading to overvoting, which the New York Stock Exchange had found to be a frequent occurrence in some instances.
Margin Calls May Force a Stock Sale at the Market Bottom
During the week ending October 13, 2008, the average stock price plunged 18%, forcing many investors who bought stock on margin to sell, which was probably a major factor contributing to the steep decline. For instance, according to the above article, Aubrey K. McClendon, chief executive of Chesapeake Energy, was forced to sell his entire stake of 33.5 million shares in his company at a price range of $15 – $22 per share. In July, the stock price was above $60 per share. Sumner M. Redstone, the chairman of Viacom and CBS, was forced to sell $400 million of shares in his companies to pay down debt. One senior wealth management executive reported that people with $30,000,000 in their brokerage accounts were wiped out in days.
This illustrates the risks of using margin: you may be forced to sell at the very time when stock prices hit bottom! And since other investors will also be forced to sell in the declining market, the market declines even further. When the stock market starts declining, it is best to sell some stock to lock in gains and to pay off margin; otherwise you will be forced to sell low after you bought high.]]>
Buying stock on margin