Category Archives: Margin

the Chinese stock market now

July 7, 2015 By in China, Hong Kong, margin trading, Stock Connect Tags: , , , , 1 Comment

declining stocks

Until about a month ago, Chinese stocks were soaring.  Over the prior year the main indices in both Shanghai and Shenzhen were up by about 150%.

Since then, however, both markets have been in a continuous tailspin, dropping a quarter of their value.

Beijing has just announced emergency stock market stabilization measures aimed at halting the fall, on the idea that swooning stocks will hurt capital formation (duh!) and clip a percentage point or more from economic growth–at a time when China doesn’t have that many points to spare.

What’s going on?

As part of its plan to gradually modernize its equity markets and ultimately open them to the outside world, China introduced margin trading (as well as stock index futures and short-selling) domestically in 2010.  China is now going through what all emerging markets eventually do–its first full-blown margin trading crisis.

margin trading

There are lots of ins and outs to margin trading, but it’s basically using the stocks you own as collateral for loans to buy more shares.  It can be very seductive when stocks are going up.  And it’s immensely profitable for brokers.  So it’s not surprising that margin loans are easily available to lots of customers.  Also, in many emerging markets, China included, it’s relatively easy to circumvent restrictions on margin lending by arranging bank loans collateralized by stocks that may not technically be margin borrowing, but effectively are the same thing.

The key aspect of margin trading is that the value of the securities in the account must exceed the margin loan total by a certain safety amount.  If prices fall to the extent that the safety amount shrinks, or is wiped out, the broker has the right to sell enough securities from the account to restore it.  He may call the client and give him the opportunity to add more money to the account   …or he may just sell.

However, this selling itself depresses prices further–eroding the value of the remaining securities in the account as well as any safety amount that may be built up.

Also, margin traders around the world tend to be both the ultimate dumb money and the ultimate herd animals.  They all but the same speculative stocks and they (almost) all leverage themselves to the eyeballs. Even if customer A is initially in fine shape, the selling in the accounts of customers B,C and D will pressure the margin balance of A as well as their own.

The first selling, then, tends to create an accelerating cascade of more selling that’s extremely hard to stop.

This is what China is experiencing now.  This is also why the government has stepped in with a massive market support operation to try to staunch the flow.

effect on the rest of the world?   …especially you and me

The Stock Connect linking mechanism between Shanghai and Hong Kong–aimed a diverting funds away from soaring mainland stocks–is now exporting the mainland weakness in much milder form to the Hang Seng.

Beijing has a ton of money and its stock markets are, realistically speaking, still not very open to the outside world.  As the current anticorruption campaign shows, the CCP has lots of ways to punish people who do stuff it doesn’t want.  So I imagine that the government will stop the downward stock market momentum.  The big questions are:

–how long will it take, and

–how large an unwanted portfolio of stocks (which will act as an overhang on the market) will Beijing have to purchase in order to achieve the stabilization it wants.

My answers are:

–I don’t know, but probably not more than a couple of weeks, and

–I don’t care, because I think the way to play a potential rebound from oversold levels is through the Hong Kong stocks now being sold by mainlanders.

cooling the Chinese stock market fever

April 17, 2015 By in "naked" short selling, Banks, China, commodies speculation--stabilizing or destabilizing?, Investment firms, Margin, securities markets, short selling, stock market Tags: , , , , , , , , 1 Comment

In the 1990s, Alan Greenspan, the head of the Fed back then, famously warned against “irrational exuberance” in the US stock market, but did nothing to stop it   …this even though he had the ability to cool the market down by tightening the rules on margin lending.  This is the stock market  analogue to raising or lowering the Fed Funds rate to influence the price of credit, but has never been used seriously in the US during my working life.

The  Bank of Japan has no such compunctions.  It has been very willing to chasten/encourage speculatively minded retail investors by tightening/loosening the criteria for borrowing money to buy stocks.

 

We have no real history to generalize from in the case of China.  But moves in recent weeks by the Chinese securities markets regulator seem to indicate that Beijing will fall into the stomp-on-the-brakes camp.

Specifically,

–at the end of last month, the regulator allowed (ordered?) domestic mutual funds to invest in shares in Hong Kong, where mainland-listed firms’ shares are trading at hefty discounts to their prices in Shanghai

–highly leveraged “umbrella trusts” cooked up by Chinese banks to circumvent margin eligibility requirements have been banned,

–a new futures product, based on small and mid-cap stocks, has been created, offering speculators the opportunity to short this highly heated sector for the first time, and

–effective today, institutional investors in China are being allowed to lend out their holdings–providing short-sellers with the wherewithal to ply their trade (although legal, short-selling hasn’t been a big feature of domestic Chinese markets until now, because there wasn’t any easy way to obtain share to sell short).

What does all this mean?

The simplest conclusion is that Beijing wants to pop what it sees as a speculative stock market bubble on the mainland.  It is possible, however, that more monetary stimulus–to prop up rickety state-owned enterprises or loony regional government-sponsored real estate projects–is in the pipeline and Beijing simply wants to dampen the potential future effects on stocks.

I have no idea which view is correct.

It’s clear, however, that Hong Kong is going to be a port in any storm, and that it is going to be increasingly used as a safety valve to absorb upward market pressure from the mainland.  So relative gains vs. Shanghai seem assured.  Whether that means absolute gains remains to be seen, although I personally have no inclination to trim my HK holdings.

 

 

speculation: stabilizing or destabilizing?

May 18, 2011 By in commodies speculation--stabilizing or destabilizing?, Current Market Thoughts, economics, Margin, Securities regulation, Trading Tags: , , , , , , , , Leave a comment

In the Panglossian world of academic finance, all markets are self-regulating and all participants are rational economic agents with the same information and motivations.

Commodity trading, where there are two different classes of market participant, with different knowledge levels and goals, really doesn’t fit in this model,.  On the one hand, farmers and miners, who are typically large corporations, want to guarantee a minimum level of cash flow for their operations.  They do so by selling a certain portion of their output for future delivery through any of a variety of kinds of commodity contracts.  The firms are deeply knowledgeable about the products they produce and sell, and they employ highly paid professional traders to do their commodity trading.  These are the hedgers.

And then there’s everyone else.

An obvious question is why someone would take the other side of the hedgers’ trades, given their superior information and high degree of trading skill.  Clearly, however, someone does, since we know that companies are routinely able to hedge their output.  Academics call these counterparties speculators.

To the academic world, it follows that speculators are a stabilizing influence.  They help to regularize the cash flows of potentially highly cyclical companies; commodities futures/forwards prices would also be higher than they are if speculators didn’t step in to take the other side of the hedgers’ trades.

In its most basic form, that’s the academic theory.

One trouble with the theory is that it’s just a generalization of the way commodities markets worked a generation ago, mixed in with the semi-religious belief in an “invisible hand” that ensures a favorable outcome in economic affairs. Worse, the basic metaphor no longer fits the facts–if it ever did.  Two examples:

1.  the silver market.  The broadening of commodities trading access to large numbers of private individuals, and the rise of commodities-oriented ETFs that give indirect access to a larger, less-affluent group, mean that some commodities markets are no longer dominated by hedgers. The “other guys” are now running the show.  And their recent behavior in silver is, to my eye, anything but stabilizing.

2.  the oil market.  Oil is an extremely economically important commodity.  Demand is highly inflexible.  Supply and demand are finely balanced.  As a result, it’s possible for speculators–whether private individuals, hedge funds or the commodity trading arms of commercial and investment banks–to be only a small fraction of all trading but still exert enough upward pressure on prices to make them, say, 10% higher (or lower) than they otherwise would be.  Prices might be stable in the sense that they don’t fluctuate much.  But a movement of this size means a major redistribution of wealth around the world.  Great for oil-producing countries, not so hot for everyone else.

In these instances, at least, speculators are a destabilizing force.

The recent ad hoc action of commodities exchanges in raising margin requirements appears to have pricked speculative bubbles in a number of commodities.  But I think it would be better for all of us if we had better regulation and a coherent framework for action.

commodities trading and margin: why volatility now?

May 17, 2011 By in emerging markets, hedge funds, Margin, Recent Market Action, Technical Analysis, Trading Tags: , , , , , , , , , , , , , Leave a comment

commodities vs. stocks

Early in my career internationally, my boss gave me the assignment of studying the palm oil and soybean markets as a step in taking over responsibility for investing in the publicly traded plantation companies in Malaysia.  One of my first stops was a visit to the head of commodities trading for Merrill Lynch in Chicago.

It was like stepping into a parallel universe.

As an equity investor, I talked about remaining calm, not acting hastily and doing thorough research.  He talked about being in tune with the rhythm of the markets, reading the charts, developing good instincts, making decisions on gut feel and having lightning reflexes.  I spoke about hiring professional researchers; he said he looked for good high school or college athletes, regardless of academic accomplishment.

margin differences

Why the difference in outlook?  It may have something to do with the difference between dealing with global demand for natural raw materials vs. the actions of managers in highly complex, but focused, corporations.  But I think it has mostly to do with the, by equity standards, extraordinarily high levels of margin leverage that commodities market participants routinely employ in their investing/speculating.  It’s cold comfort to have the long-term trend absolutely correct but to be wiped out by a 10% price fluctuation in the wrong direction later on this week.

other quirks (from an equity investor point of view)

Two other characteristics of commodities trading to note:

–exchanges typically set the margin rules

–exchanges also typically set maximum daily price movements, both up and down, for a given commodity.  One consequence of this is that there are days when the price moves to the upper/lower limit without any sellers/buyers appearing.  In this case, the market can close for the day at limit up/down, but no trade.  So you can be “trapped” in a position you want to liquidate but can’t.  Another reason to act fast on new short-term developments.

greater interest in commodities

In recent years, there’s been a lot more interest in commodities than previously.  I see several reasons for this:

–the rapid economic advancement of countries like China and India, with large populations and at a stage of development where they use increasingly large amounts of farming and mining commodities.

–the rise of hedge funds, many of which are run by traders who are familiar with commodities and who are more comfortable “reading” charts than researching companies.

–the development of exchange-traded funds based on commodities, which give individuals easy access to commodity investing they didn’t have before

–the end to almost two decades of gigantic, price-depressing overcapacity in most mineral commodities created by overdevelopment in the late 1970s- early 1980s

–the increasing complexity of finance and the concomitant development of financial derivatives.

what’s going on now?

Why the sharp recent decline in mining and food commodities?

As I mentioned in my post yesterday on margin in general, a margin call can happen in two ways:

–either the value of your account can fall below the minimum margin level, or

–the market regulators can raise margin requirements.

margin requirements rising

The second hit the commodities markets late last month.  As the New York Times reported recently, that’s when officials at the CME (Chicago Mercantile Exchange) became concerned about the near doubling in the price of silver over the prior half-year.  The CME  immediately increased in the margin requirement for silver contracts.   When that had no immediate effect on the silver price, the exchange announced a series of increases that would rapidly bring the first-day margin needed to support each contract to $21,000+.

Each silver contract is for 5,000 ounces, or about $235,000 at a $47/oz. price.  Prior to these actions, the required first-day margin was $12,000-, meaning a market participant could leverage himself by 20x in buying silver.  (Actually, the allowed leverage was higher, since maintenance margin is lower than first-day, and because exchange members are permitted to use more leverage than speculators.)

Silver now trades for $34/oz., a decline of almost 30%, mos of the fall occurring in the first week after margin requirements were changed.

Other commodities have followed suit, though not to the extent of the decline in silver, as regulators have lifted margin requirements for them as well.

why act now?

Maybe the CME is just doing its regulatory duty.  A cynical person might speculate–à la the Hunt brothers–that pressure came from exchange members on the losing side of the trade.  Another (better, I think) guess is that there was pressure from Washington, where a new regulatory framework for commodity trading is now being developed.


margin trading

May 16, 2011 By in Basic Concepts, Margin, Trading Tags: , , , , , 2 Comments

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.