Margin Trades: Buying Securities on Credit
by
Charles Lamson
When you are ready to buy securities, you can do so by putting up your own money, or by borrowing some of the money. Buying on margin, as it is called, is a common practice that allows investors to use borrowed money to make security transactions. Margin trading is closely regulated and is carried out under strict margin requirements set by the Federal Reserve Board. These requirements specify the amount of equity an investor must put up when buying stocks, bonds, and other securities. The most recent requirement is 50 percent for common stock, which means that at least 50 percent of each dollar must be the investor's own; the remaining 50 percent may be borrowed. Other securities besides stocks can be margined, and these have their own margin requirements; Treasury bonds, for example, can be purchased with a margin as low as 10 percent.
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To make margin purchases, you must open a market account and have a minimum of $2,000 in cash (or equity in securities) on deposit with your broker. Once you meet these requirements, the brokerage firm will loan you the needed funds and retain the securities purchased as collateral. You can also obtain loans to purchase securities from your commercial bank, but the Fed's margin requirements still apply. To see how margin trading works, assume the margin requirement is 50 percent and that your brokerage firm charges 9 percent interest on margin loans (brokerage firms usually set the rate on margin loans at 1 to 3 points above prime). If you want to purchase a round lot (100 shares) of Engulf & Devour, which is currently trading at $50 per share, you can either make the purchase entirely with your own money or borrow a portion of the purchase price. The cost of the transaction will be $5,000 ($50 / share x $5,000). If you margin, you will put up only $2,500 of your own money (50 percent X 5,000 shares) and borrow the $2,500 balance. This is done for two cases: (1) a $20 per share increase in the stock price, to $70 per share, and (2) a $20 per share decrease in the stock price, to $30 per share. It is assumed that the stock will be held for one year and all broker commissions are ignored.
The use of margin allows you to increase the return on your investment when stock prices increase. Indeed, one of the major attributes of margin trading is that it allows you to magnify your returns---that is, you can use margin to reduce your equity in an investment and thereby magnify the returns from invested capital when security prices go up. The return on your investment when the stock price increases from $50 to $70 a share is 40 percent without margin and 71 percent with margin. However, when the stock price declines from $50 to $30 per share, the return on your investment will be a negative 40 percent without margin and a whopping 89 percent loss with margin. Clearly, the use of margin magnifies losses as well as profits! If the price of our stock in the example continues to drop you will eventually reach the point at which your equity in the investment will be so low that the brokerage house will require either to provide more collateral or liquidate the investment. The risk inherent in buying on margin make it imperative that you thoroughly acquaint yourself with the risk-return trade-offs involved before using margin in your investment program.
Short Selling: The Practice of Selling Borrowed Securities
Most security transactions are long transactions; they are made in anticipation of increasing security prices in order to profit by buying low and selling high. A short sale transaction, in contrast, is made in anticipation of a decline in the price of a security. Although not nearly as common as long transactions, short selling is often done by the more sophisticated investor as a way to profit during a period of declining prices. When used by individual investors, most short sales are made with common stocks. When an investor sells a security short, the broker borrows the security and then sells it on behalf of the short seller's account---short sellers actually sell securities they do not own. The borrowed shares must, of course, be replaced in the future. If the investor could purchase the shares at a lower price, a profit will result. In effect, the objective of a short sell is to take advantage of a drop in price by first selling high and then buying low.
Short selling is perfectly legitimate; there's nothing illegal or unethical about it. Indeed because the shares sold are borrowed securities, numerous rules and regulations protect the party that lends the securities and govern the short-sale process. Once regulation, for example, permits stocks to be sold short only when the last change in the market price of the stock has been upward. Another safeguard is the retirement that all proceeds from the borrowed securities be held by the brokerage firm---the short seller never sees any of this money! In addition, the short seller must deposit with the broker a certain amount of money (equivalent to the prevailing initial requirement) when the transaction is executed---so even a short-sale transaction involves an investment of capital.
A short-sale transaction can be illustrated with a simple example (one that ignores brokerage fees). Assume that Patrick O'Sullivan wishes to sell short 100 shares of Advanced Buggy-Whips, Inc. at $52.50 per share after Pat has met the necessary requirements (including making a margin deposit of $52.50 x 100 x 50% = $2,625), his broker borrows the shares and sells them, obtaining proceeds o $5,250 (100 shares x $52.50/share). If the stock price goes down as Pat expects, he will be able to repurchase the shares at the lower price. Now suppose the price drops to $40 per share, and he repurchases the shares at the lower price. Now suppose the price drops to $40 per share, and he repurchases the 100 shares. Pat will make a profit because he will have been able to replace the shares for four thousand dollars (100 shares x $40 per share, and he repurchases the 100 shares. Pat will make a profit because he will have been able to replace the shares for $4,000 x $40 per share), which is below the $5,250 received when he sold the stock. His profit will be $1,250 ($5,250 - $4,000), if on the other hand, the stock price rose to, say, $60 per share, and Pat repurchased the stocks at that price, he would sustain a loss of $750.00) Because of the high risk involved in short sales, you should thoroughly familiarize yourself with this technique and all of its pitfalls before attempting to short sell any security.
*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 456-459*
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