What does Investing with Margins Mean?

Published by Evan Louise Madriñan on 24/07/202324/07/2023

by elmads

Introduction

“Give me a firm place to stand and a lever, and I can move the earth.”

-Archimedes

Lever, an invention of our ancestors that substantially spurred human progress. It is used as a means to move a heavy or firmly fixed load with one end when pressure is applied to the other.

A simple yet very important innovation. With it, civilizations have been created throughout our history at a faster pace, like infrastructure, as it substantially reduced the time and effort required to finish them.

The word “leverage” is the outcome our society has gained from the usage of levers since our ancestral past. The person(s) gained a substantial advantage by using the lever. Thus, the well-known quote of the Greek Philosopher Archimedes, which I shared at the start of this blog.

As time passed, the word “lever” was used in different fields worldwide, one of which was finance. Though in the financial world, a lever is not used to lift objects using the two factors of fulcrum and load.

As with lifting heavy objects, using a lever will substantially give us the upper hand by using such tools to our advantage. “Leverage” allows us to gain strength and advantage with less effort (than without using one).

And in the financial world, a place where money either makes more money or loses more money via the financial markets, leverage means using debt to gain additional capital through borrowing in the hopes that potential profits will amplify returns.

So, the next time you hear someone say that they’re using leverage in the markets, it means that they used debt on top of their cash to invest in the financial markets.

Investing with Margins

There are a handful of investors and traders who use debt in order to make more money from their own initial capital. It is a very rewarding endeavour if done right, but we’re talking here about debt, and nothing comes out 100% well with debt if not handled with care.

Let’s talk about what investing in stocks without margins is first. It is the known way of investing in stocks, where we place our hard-earned cash in our chosen brokerage account, then use it to purchase shares or stocks of a company or companies.

Whereas with Margin Investing, we need to open a separate account, which is different from the ordinary cash account of a brokerage firm. In a margin account, we borrow money from the brokerage firm itself.

The company shares we own in our margin account will then be the collateral for the margin loan. Additionally, like with any other loan, we’ll need to pay interest on our debt.

Initial Margin Requirements

The best way to explain how this works is through a scenario.

We have Mark, who has $10,000 that he would like to invest in Company QRS (a sample company only). Mark has a strong conviction that company QRS’ market price will go up based on his own analysis of the underlying business. Due to his strong belief in his own analysis, he is willing to take a higher risk when investing in company QRS with high margins.

Mark has already opened his own Margin investment account via his own broker. There is a certain amount of money that an investor needs to have before he/she is approved to have his/her own margin investment account, which is dependent on every brokerage firm.

Mark contacted his own broker and asked what he would need to do in order to qualify to invest in a publicly traded company through margins. His broker told him that he could invest an amount that was 50% of the “Initial Margin Requirement”.

Initial Margin Requirement  – This is the initial amount of money an investor is required to place in a leveraged investment. In the US, the Federal Reserve (the US Central Bank) limits how much a person can borrow on margin on an initial trade. The Federal Reserve has placed the Initial Margin Requirement at 50% since 1974; it has not changed since then. This means that brokerage firms can only lend 50% of the total purchase price of newly bought stock.

In Mark’s case, his brokerage firm asked for a 50% Initial Margin Requirement to invest in Company QRS. This means that he needs at least 50% cash out of the total amount of money he wants to invest in the company.

Mark said that he wants to invest a total of $20,000 in company QRS. And, because he has $10,000 worth of cash in his margin account, he then qualifies to enter a position.

50% of $20,000 = $10,000 (Mark qualifies for the Initial Margin Requirement).

NOTE: Let’s say you want to invest $1,000 total in a stock with margins, while your broker requires an initial margin requirement of 50%. You are then required to put in $500 in cash first, and then your broker will loan you the other $500. Margin requirements can be higher for other brokers; they can be 60% or 70% of the cash required as a down payment of the total amount you want to invest.

Margin Interests

All corporate loans have a corresponding interest payment, and this too applies to margin debt.

To compute this, we have to know the margin interest rates of your own chosen margin account broker. For example purposes, I’ll use Fidelity Investments margin interest rates table as of December 2022. See the photograph below.

Let’s use Mark’s scenario to grasp the concept of margin interest rates, and we’ll also use Fidelity Investment’s margin interest rates.

The debit balance in Mark’s account is worth $10,000; therefore, he would need to pay 12.575% annually for the $10,000 he loaned from his brokerage firm.

• Amount of money borrowed * Annual Interest rate = Interest payment
• $10,000 * 0.12575 (12.575%) = $1,257.5

But what if Mark paid his margin loan after 25 days? Recall, that the 12.575% is an annual margin interest rate, not on days. With this in mind, we will need to compute the margin interest rates on a daily basis.

• Interest Payment/360 Days (the brokerage industry usually uses 360 days instead of the standard 365 days in a year).
• $1,257.5 / 360 days = $3.49 daily
• Daily interest payment multiplied by the number of days money owed.
• $3.49 x 25 days = $87.25

Mark will need to pay a total of $87.25 as interest to his broker over the span of 25 days.

Scenario 1: Stock Price Rises

What happens if the stock price rises? Let’s say that Mark’s projection materialises and Company QRS’ stock price goes up 25%.

• Mark’s total invested capital and market value = $20,000
• Mark’s Equity of Company QRS Shares = $10,000
• Mark’s Owed Money/Margin Loan = $10,000

Stock price increases by 25% = Initial $20,000 is now worth $25,000 (= $20,000 + [$20,000 * 25%]).

Mark sells at a 25% gain.

Breakdown:

Mark will pay his principal margin loan of $10,000, including the cost of borrowing the debt (interest payment) and some commission from the broker.

For example, we’ll exclude commission fees.

Mark will pay back the $10,000 debt + $87.25 (interest payment on the debt for having it for 25 days) = $10,087.25.

Mark’s total take-home money is $14,912.75 ($25,000 minus $10,087.25).

This gives him a total investment gain of 49%, which has been made possible by taking on leverage.

• Buying power = $20,000
  • Own Cash Invested = $10,000
  • Margin loan = $10,000
• Take home money after debt responsibilities and fees = $14,912.75
• Percentage Gain = ($14,912.75 – $10,000)/ $10,000
• Percentage Gain = 49.13%

Without utilising margins—using only his own $10,000 cash to invest—it would only give him a 25% gain, with a take home of $12,500.

• Own Cash Invested = $10,000
• Take home money = $12,500
• Percentage Gain = ($12,500 – $10,000)/ $10,000
• Percentage Gain = 25%

Scenario 1: Stock Price Falls

In here, Mark’s projection misses, where the stock price of company QRS fell 25%.

• Mark’s total invested capital and market value = $20,000
• Mark’s Equity of Company QRS Shares = $10,000
• Mark’s Owed Money/Margin Loan = $10,000

Stock price decreases 25% = initial $20,000 is now worth $15,000 (= $20,000 – [$20,000 * 25%]).

Mark sells at a 25% loss.

Breakdown:

Mark will pay his margin loan of $10,000, including the cost of borrowing the debt (interest payment).

Mark will pay back the $10,000 debt + $87.25 (interest payment on the debt for having it for 25 days) = $10,087.25.

Mark’s total take-home money is $4,912.75 ($15,000-$10,087.25), which is a -50.87% loss from his initial $10,000 own cash invested.

• Buying power = $20,000
  • Own Cash Invested = $10,000
  • Margin loan = $10,000
• Take home money after debt responsibilities and fees = $4,912.75
• Percentage Gain = ($4,912.75 – $10,000)/ $10,000
• Percentage Gain = -50.87%

If Mark did not use margins to invest in company QRS, using only his own $10,000 cash to invest, his losses would only be -25%, equalling $7,500.

• Own Cash Invested = $10,000
• Take home money = $7,500
• Percentage Gain = ($7,500 – $10,000)/ $10,000
• Percentage Gain = -25%

Investing with margins amplify both investment gains and losses.

Maintenance Margin

Every margin account has a set initial margin requirement, where before entering a position on margin, the broker requires the investor to place a certain amount of money relative to the total amount of money that will be placed on an investment. In Mark’s example, this has a 50% initial margin requirement.

It doesn’t stop there, as brokers and exchanges also require a maintenance margin, which is different from the initial margin requirement.

So, what is a maintenance margin? It is the required percentage amount of cash you should have on your margin account relative to your margin investments’ market value.

The maintenance margin percentage required varies for each broker and market exchange; some ask for 25% while others are higher. For example, we’ll be using a 35% maintenance margin requirement.

Going back to our Mark examples, using scenario 2, where the stock price of company QRS went down by 25%

• Mark’s total invested capital and market value = $20,000
• Mark’s Equity of Company QRS Shares = $10,000
• Mark’s Owed Money/Margin Loan = $10,000
• Current Market Value = $15,000 due to the 25% drop

Breakdown:

• Current Market Value = $15,000
• Debt owed to broker = $10,000
• Mark’s equity = current market value minus debt owed to the broker
  • Mark’s equity = $15,000 minus $10,000
  • Mark’s equity = $5,000
• Mark’s equity divided by the current market value
• $5,000 / $15,000 = 33.33%

Recall that Mark’s broker requires AT LEAST a 35% margin requirement; unfortunately, due to the fall in the market value of his investment, it dipped below the said requirement. Currently, it is at 33.33%, which is less than the required 35%.

Mark’s broker will contact him and inform him that he needs to put in additional cash to his margin account to get the total cash equity of his account back to the maintenance margin of 35% and above. This is called the “Margin Call”.

To achieve this, Mark would need to put AT LEAST $250 in his account to make his total cash equity $5,250.

• Mark’s equity divided by the current market value
• $5,250 / $15,000 = 35%

In the event that Mark refuses to add cash to his account, his broker will immediately sell his positions.

The broker is allowed to do this because, remember, they use the shares held in a margin account as collateral. This is how they use the shares as collateral as a means to mitigate losses on the brokers’ side.

Maintenance margin is one of the risk management methods taken by brokerage firms and exchanges that offer margins on investments and trades.

The remaining equity of Mark’s trade will be returned to him, while the broker will take back Mark’s owed money, including the commissions and interest payments. It’s still a win for the broker.

Let’s Sum It Up

Investing with margins amplifies our gains if done with accuracy and precision, but because we’re taking on debt to make more money, it also means that it is a double-edged sword where losses are also intensified.

This method of investing is a very high-risk game; taking this path means shifting gears to its highest level. It’s not for everyone, as fortunes are destroyed more frequently than made on this path.

There was a time when Warren Buffett and Charlie Munger had a third partner, but things changed when their third partner got impatient and wanted to get rich quickly.

In 2008, Mohnish Pabrai, a money manager who ran Pabrai Investment Funds, was the winner of the lunch with Warren Buffett after bidding more than $650,000 on eBay for a meal with him. Pabrai asked Buffett during lunch what had happened to Rick Guerin. In an interview with The Motley Fool on January 3rd, 2013, Pabrai had this to say about Buffett’s response to his question:

“I’ve met Rick recently, but he disappeared off the map, so I asked Warren, Are you in touch with Rick, and what happened to Rick? And Warren said, Yes, he’s very much in touch with him.

And he said, Charlie and I always knew that we would become incredibly wealthy. And he said, We were not in a hurry to get wealthy; we knew it would happen. He said Rick was just as smart as us, but he was in a hurry. And so actually, what happened—some of this is public—was that in the 1973 and 1974 downturns, Rick was levered with margin loans. And the stock market went down almost 70% in those two years, and so he got margin calls out the yin-yang, and he sold his Berkshire stock to Warren. Warren actually said, I bought Rick’s Berkshire stock at under $40 a piece, and so Rick was forced to sell shares at… $40 apiece because he was levered. 

And then Warren went a step further. He said that if you’re even a slightly above-average investor who spends less than they earn over a lifetime, you cannot help but get rich if you are patient. “

For most people in this world who trade and invest, taking on margins is a faster way to get poor than getting rich.

Debt, for most of us, has never been very helpful. Always be careful when handling debt, both in personal finance and investing.

Debt is neither good nor evil.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.