Margin

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Investing on margin is an approach sometimes used by well-off and / or experienced investors hoping to magnify gains, and is one approach used to obtain leverage. A general description of the use of margin is given here[1]. It entails borrowing to invest. The borrowing is from their discount brokerage, and at a rate prescribed by the broker.

Margin use is prohibited in registered accounts, both because of the risk of losing the entire portfolio (see below), and because additional contributions to a registered account (to pay margin interest or to avoid a margin call) may not be allowed for all investors.

Creditworthiness

In order to borrow, the prospective borrower must show that he is creditworthy, and must have a "margin account" at the brokerage. This generally means having an account size larger than a brokerage-prescribed minimum, as well as the filling out of additional forms to show that the investor qualifies for margin (both investment knowledge and risk appetite). A Margin Disclosure Statement provided by a major brokerage is here, and includes a warning as well as a discussion of the risks.

Selling puts

Another use of a margin account, using no direct borrowing (hence no margin interest due) is for writing (selling) put options. By doing this, the investor assumes the obligation to buy specific securities at predetermined prices, which means that at some point(s) in the future, the account cash balance may become negative. This, again, is an approach only used by experienced investors, although the put-call parity relationship[2] states unequivocally that writing puts together with cash set aside for a potential assignment is exactly equivalent with buying the stock and writing a covered call on it, often cited as the least dangerous option strategy.

Collateral

The collateral used for the margin is based on the holdings within the margin user's account. Different securities can be used as margin to different proscribed limits, based on brokerage and exchange regulations. If a security can be used as "50% margin", that means that $50 can be borrowed (at the brokerage's interest rate) for every $100 invested. The brokerage will proscribe a minimum amount of collateral. If the value of the securities used as collateral falls, the investor will receive a notification (a margin call[3]) requiring him or her to either put up more collateral or be sold out of positions. The brokerage usually provides this as a courtesy and it reserves the right to close out any positions from the account until margin requirements are met.

Investment Industry Regulatory Organization of Canada (IIROC)[4] periodically publishes a list of securities eligible for reduced margin, currently 30%, meaning one can buy $100 worth of securities by putting $30 down and borrowing the rest from the broker. Of particular interest is the appendix stating the criteria used in defining that list.

Margin interest

The margin interest rate can be as good or better than the interest rate on a home equity line of credit (HELOC).[citation needed] Note that the rate of return on the investments purchased on margin is reduced by the prescribed margin rate.

On the other hand, margin interest can be tax deductible[5][6] in the tax year in which it was paid.

Investors who are considering using margin should compare the rates offered by different brokers before deciding.

Usage

Although using margin can increase gains, it also magnifies losses, and in the extreme, can cause the investor to be wiped out.

Margin investing is often used by hedge funds.

Many investors are not psychologically suited to using margin because it magnifies the risk. This contrasts with home buying, where the same investor may have bought his residence with 10% down (i.e., 10x leverage) -- there is no direct danger of "margin call" on a principal residence, although at refinance time one can get similar results if house prices have declined substantially.

The Stock Market Crash of 1929 was felt to be in part to be due to excessive use of leverage.[7]

Securities lending by the brokerage company

Opening a margin account involves the investor agreeing to the brokerage company being able to segregate some (potentially all) the account holdings and lend them to short sellers, making the short selling process possible. Note that the brokerage gets to pick which of the account holdings it may lend, and only up to the amount currently borrowed by the investor.

See also

References

  1. Wikipedia. Margin (finance), viewed Dec. 16 2011.
  2. Put-call parity, viewed Dec. 16, 2011.
  3. Margin call, viewed Dec. 16, 2011.
  4. IIROC is the national self-regulatory organization which oversees all investment dealers and trading activity on debt and equity marketplaces in Canada.
  5. "Line 221 - Carrying charges and interest expenses". Canada Revenue Agency. http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/ddctns/lns206-236/221/menu-eng.html. Retrieved January 10, 2017.
  6. "Interest expense and other investment expenses". TaxTips.ca. November 28, 2016. http://www.taxtips.ca/personaltax/investing/interestexpense.htm. Retrieved January 10, 2017.
  7. The Great Crash (1929), J.K. Galbraith.

Further reading

External links