Mitchell Thomas, The Daily Record Newswire
Margin accounts have been utilized by sophisticated investors for decades to leverage their purchasing power when buying securities.
The purpose for a margin account is to borrow money from a firm to purchase securities beyond your original cash amount. Federal rules and regulations are structured into a signed margin agreement to satisfy and protect the lender from escalating losses in a declining market.
For an investor to initiate a margin account he needs to be completely aware of the nuances within the margin agreement of fees, interest and equity maintenance standards. The margin agreement is a contract with stipulations that the client must adhere to.
The minimum amount for an investor to open an account is two thousand dollars. The investor is then allowed to purchase a marginable security with a total value of four thousand dollars. The agreement equates to two thousand from the firm and two thousand dollars in equity.
If the security appreciates, the amount of equity increases and the two thousand borrowed remains intact (excluding fees), rewarding the client. Unfortunately, when there is an upside, a downside equally exists. We have all been subject to a down market and that scenario complicates the margin account. The standard equity to be maintained is at least 30 percent of the total account.
If the equity falls below this threshold then the necessity for the client to bring the account above the minimum maintenance is required; this is called a maintenance call. That must be done within a day by adding cash, adding paid marginable securities to the account, or liquidating the necessary securities in the account.
An example of a hypothetical margin maintenance call will provide clarity. A client deposits two thousand dollars to the account and immediately purchases 100 shares of a security for forty dollars a share. The securities begin to drop in value from their original purchase price of $40. Let's say the stock value falls to $30, this would give the account value a decline to $3,000, requiring an equity value of at least $900 to maintain the margin requirement.
The $2,000 will still be owed to the firm on the loan and the equity of $1,000 would still be above the margin call. If the underlining security later falls to $25 your equity is diminished to $500 and you would be required to deposit at least $250 to increase your equity to 30 percent of the account.
A fed margin call is when the account drops to 25 percent of equity in the account. This requires the client to either deposit funds or marginable securities to bring it above the threshold. The broker has the requirement to make an attempt to notify you of this situation immediately. If you are unable to respond to this inquiry the broker is obligated to liquidate securities to bring the account in accordance to the agreement.
When total reported margin debt takes a significant downward motion from abnormally high levels the general equity market may be signaling a downturn. .
Historical statistics reveal measuring margin debt to GDP as a percent typically peaks just before market downturns. Dates like Aug. 1987, Dec. 1999, early 2007, and April 2015 had seen peaks prior to the market decline. We have seen a reduction of 14.3 percent since last April. The end of QE and the slight increase in interest rates is a strong consideration for this reduction; borrowing fees in this type of account have slightly increased, reducing potential returns.
Another historical measure is the total amount of margin debt that exists before market downturns. In January 2007 the NYSE reported margin debt was $285 billion. Five months later margin debt escalated to $353 billion which is approximately a 24 percent increase, it further increased to $381 billion by August of that year.
This elevated speculation was just before the collapse of the mortgage market and subsequently the stock market followed. This is a singular indicator and not necessarily an absolute precursor to a severe market direction reversal.
Margin is an investment tool that should be treated with an investor's degree of tolerance for risk prior to delving into unchartered waters. It is important to have an initial conviction to your investment and the flexibility to reassess your original premise if the security or market turns away from you. Preconceived assumptions may prove to be wrong.
Margin is a strategy of balance; it requires the savvy investor to maintain skin in the game, utilizing staying power to absorb the stress and complications while being aware of when to abandon ship to avoid financial devastation. All market environments present potential lucrative opportunities. Margin debt can be a useful tool if treated with the knowledge of its potential hazards.
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Mitchell Thomas is an International Equity Analyst/Portfolio Mgr./Head Trader for Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford. Call 585-586-4680.
Published: Mon, Apr 25, 2016
