I want to write about two related topics:  what’s going on with violent gyrations in commodities markets (tomorrow) and the more general issue (Wednesday) of whether speculation can be destabilizing as well as stabilizing (academics deny the first is possible).  Today’s post on margin trading lays a foundation by discussing the tool–financial leverage–many speculators use to try to enhance their returns.

the basics

what margin is

In its simplest form, a speculator/investor trades on margin when he borrows money, usually from the broker or other counterparty he is transacting with, to buy securities.  He uses the value of these securities + additional cash or securities he has on deposit with the counterparty, as collateral for the loan.

Margin trading is a global phenomenon, both in the sense that it occurs in all the countries I’m aware of where securities are traded, and in the sense that it occurs over different classes of securities–stocks, bonds and commodities.  The precise rules and regulations differ from country to country, and the mechanics may differ in a given country, depending on the type of security.

the margin calculation

The ground-level calculation in margin trading is the “margin,” or net collateral, figured as a percentage of the gross collateral.  That is:

(value of the collateral in the account minus the amount of loans secured by the collateral)  ÷  the value of the collateral.

For example, if I deposit $10,000 with my broker, borrow another $10,000 from him and use the money to buy $20,000 of XYZ stock, I am trading on margin of 50%.   ($20,000 in securities – $10,000 loan  =  $10,000 ) ÷ $20,000 value of XYZ shares  =  50%.

minimum margin requirements

Typically, a country’s central bank or some other finance-related authority sets out a general framework for margin trading in stocks and bonds in that country.  A commodities exchange may serve the same function.

Some countries actively change margin requirements as a tool of economic policy.  The US did this in the early twentieth century, but not today.  (The Federal Reserve has a curious formula for stocks.  Generally, margin must be at least 25% (maintenance margin); however, on the day of purchase, the margin for new buys–but not the account as a whole–must be 50% (first-day margin).)

While your counterparty can’t offer easier credit terms than the general guidelines allow, it can, and usually does, set more stringent requirements.

Things also get more complicated if you have both long and short positions.  But in this post, I’m not going to worry about that.

collateral

Not every security can be used as collateral.  Typically, small capitalization or illiquid stocks, or stocks traded on foreign exchanges, are not marginable. 

what makes it attractive

For the broker, the answer is easy.  He makes a spread between his cost of funds and the broker loan rate, what he charges you in interest on your margin loan.  In addition, he earns more on the additional trading you do.  And he typically can earn fees by using your collateral in securities loan programs.

The investor/speculator can leverage his insights into securities markets with a larger pool of investment funds, provided the ideas earn more than the interest payments on the borrowed money.

Guess who usually gets the better side of the bargain?

margin calls

What happens if the margin in your account falls below the minimum requirements?

It’s important to note that this can happen in two ways:

1.  your stocks can decline in value, and/or

2.  the margin requirements can be changed, either by the regulator or by your broker.

The popular perception is that a margin call means that someone reaches you by telephone, tells you that your account has dipped below the minimum margin requirement and gives you time to add enough new collateral to restore your margin to the minimum level.

Notifying you, or even attempting to notify you, however, is not a legal requirement, at least in the US.  In fact, in the margin agreement you sign, you acknowledge that you understand the broker can change margin requirements without letting you know, and that he can sell securities in your margin account to repay enough of your margin loan to restore the minimum margin–again without notifying you.

If your broker begins to sell securities in your account, you have no control over which ones he sells.  Because his primary obligation is to protect his firm from facing a loss on its margin loan, he will typically sell as much as he can as fast as he can.  In other words, the most liquid stocks go first and he won’t spend a lot of time “working” the order to get the most favorable price for you.  Nor will he let you set limits.

From watching from the sidelines, I can tell this is not a pleasant experience.

Even worse, if your entire securities account is liquidated in the process, but there’s still a loan balance outstanding, you’re obligated to pay this as well.

On that cheery note, I’ll end for today.  Commodities tomorrow.