Margin Trading: The Goods And Bads Of Mr. Leverage
When investing in the stock market, you have an options opening a cash account or a margin account.
A cash account is one you pay for your stock purchases in full with cash. A margin account lets you buy stocks with borrowed money from the broker you are trading with.
This comes at a cost, advantages, disadvantages and horrific consequences.
The advantage of buying stocks with margin is the leverage. Under current rules and regulations, investors can margin himself to 50%.
This means a 2 to 1 leverage. For every dollar in upwards move of stock, you would double the profit.
However, leverage can be a double-edged sword. For every dollar in downwards move of stock, your loss would be doubled too.
Suppose you borrow 50% of the stock purchases and the stock price gets cut in half in a crash, you will contact with a fairly nasty message.
You will be asked to put up more cash into the account to carry the stocks. If you don’t by the dateline, usually within 3 days, your account will be liquidated (sold).
The broker will sell your stocks in the open market to redeem his margin – money you borrowed him. This doesn’t discount if several days later stock recover and starts to move back up again.
Brokers at work on the floor of the Stock Exchange
During the roaring 20s, the margin requirement was very loose. Investors leveraged themselves to the hills. Some borrowed to 90% of stock value, much like today real estate speculation.
The market was overheat and bubble was blown up under no financial strength of the company at all.
Everyone wanted to make quick bucks. When the market finally turned south, panic selling set.
Most investors couldn’t put up cash and margin calls echo all over in the market. And this ignited the Great Depression of the 1930s.
In the options market, when an investor/trader sell naked options, he will have to put up a hugh margin.
Because the potential loss of the trade, margin can be many times over the premium collected on the naked selling.
I knew one person who is involved in selling naked call options when stock was $20.
This got really excited and moved up fast. He had to put up millions of dollars on the way up and finally when it got to $180.
He felt that was enough and got out of the trade just to be informed later that stock moved down again. But he was too late and out of the game.
Back in the late 90s, there was a company called Long Term Capital Management. Basically, they sold naked put options.
As the Asian economy went into crisis and world market moved in the opposite direction of what LTCM expected, their naked positions blew up. This company lost so much money that it single-handedly brought down the entire US-market.
Category: Stocks Market
