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What in the world is margin trading?
It's no secret that the advent of credit did wonders
to beef up our modern economy, and the stock market has been no
exception. While most new investors buy stock through traditional
cash accounts, which force you to pay for securities either by adding
cash to the account or selling stock within three trading days of
purchase, there is another way. It's the siren song of buying on
margin, and while it can be a great way to get a little more return
than your cash would normally net you, it also can lead to a quick
dunk in some hot water.
Margin accounts allow
investors to buy a lot of shares
with a relatively small amount
of cash up front by using the
assets currently held in their
accounts as collateral.
Mr. Greenspan and
his cohorts at the Federal Reserve
set the initial requirement
needed to buy stock on margin.
As of now it's 50 percent or $2,000
-- whichever is higher -- meaning
that if you want to buy $10,000
worth of Intel you'd need assets
worth at least $5,000 in your
account, but if you wanted to
buy $2,500 you'd need at least
$2,000.
But the Fed isn't
the only regulator in the margin
game: Stock exchanges and brokerages
also set their own requirements.
Some, like Schwab for example,
tend to be strict about buying
penny stocks or highly volatile
Internet stocks on margin. Others,
such as Datek, are more lenient.
As in any borrower-lender
relationship, brokerage firms
make money on margin accounts
by charging interest on the
debit balance. Your equity in
the account rises and falls
as the price of the stock rises
and falls but the debit balance
remains the same -- except for
the accruing interest, which
is at an annual rate of anywhere
from 8 percent to 10 percent at the moment
-- until you repay the debit.
Here's how it works: Suppose you
want to buy 100 shares of Intel
on margin. If Intel is trading
at $100 a share, that means
you want to borrow $10,000.
The 50 percent requirement means you
need at least $5,000 cash in
your margin account. Your broker
then loans you the remaining
$5,000. Your equity is $5,000
and your debit balance is $5,000,
plus interest.
At the close of the
day that you open the margin
account, Intel has gone up to
$110. The market value of your
account is now $11,000. Your
equity is now $5,998.75 -- $11,000
minus $5,001.25 (the debit balance
plus annualized interest of
9%) -- that's nearly 500 bones
you would not have made without
that loan from your broker.
Of course, stock
prices fall as well as rise
and that's where margin accounts
get you into trouble. Suppose
Intel drops to $90 a share.
The market value of your account
is now only $9,000. Your debit
balance is still $5,001.25,
but your equity is only $3,998.75
-- about a grand short of the
originally required 50%.
Here's where it gets
really tricky. Falling below
the 50 percent threshold can trigger
a "margin call" -- when brokers
request additional funds or
securities because the value
of the account has fallen below
the minimum. If you don't have
the cash, they can liquidate
the stock you bought on margin
and any other stock in
your account to raise enough
cash to bring you back to the
minimum.
As with most complicated
investing plays -- like short
selling -- investing on margin
requires a lot of research and
a big helping of guts. You should
have good reason to believe
a stock will rise and quickly,
because if it's going to be
an investment that more closely
resembles the tortoise than
the hare, the interest will
likely negate your returns.
And to avoid margin calls, leave
yourself enough squish so that
you don't begin with a 50 percent loan
- try 10-20 percent to get a feel for
how it works.
Just like credit,
investing on margin can be a
boon for those who know how
to handle it; however, also
like credit, there's always
a chance that you'll dig yourself
a hole.
-- Posted: March 1, 2000
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