Utilizing leverage and margin can be wildly profitable; however, if not used carefully and properly it can lead to ruin. Ironically, its application is quite simple and painless to utilize, in fact, one might not even he is using it, and certainly to what extent it is being used. Actually, it's your brokerage credit card. You see it, you want it, you buy it, it's that simple. Nothing to swipe, nothing to sign, with a simple click of your mouse you just bought a 1000 shares of XYZ, guaranteed to build your fortune. Wow, can anything be better than securing you future with OPM — "Other People's Money"?
From what I have just written, you might think I'm against leveraging and margining your brokerage account. You'd be wrong. Actually, I'm strongly in favor of leverage, however, you'd better know not to abuse it, if so, you can get seriously burned; and worst case scenario, wiped out and forced to exit the market.
Excerpted from Wikipedia:
Leverage is any technique to multiply gains and losses. Most often it involves buying more of an asset by using borrowed funds, with the belief that the income from the asset or asset price appreciation will be more than the cost of borrowing. Almost always this involves the risk that borrowing costs will be larger than the income from the asset, or that the value of the asset will fall, leading to incurred losses.
Although leverage is commonly utilized by commercial enterprises, for our purposes, I am limiting the parameters of this article to individual investors and their use of leverage to margin their brokerage account, which is basically borrowing money to purchase securities, also known as buying on margin.
However, this article is dedicated to instructing investors how to avoid the pitfalls of over-leveraging their accounts, which under even minimally adverse circumstances, could result in a dreaded margin call. Yes dreaded, it happened to me only once, and I've made certain it would never happen again. A margin call is simply a request from the broker, asking the investor, to either add money to his account to meet its maintenance margin requirement, which is usually 25% of the total market value of the securities held in that margin account. If not, the brokerage will unilaterally begin selling positions sufficient to bring the account back into compliance. Compliance parameters are routinely set at the above-mentioned 25%, however it could be as high as 40%. It might be wise to consult your broker if you have, or are considering, setting up a margin account.
From troubling personal experience, my broker, during the recent market contraction, sent out a general notice that they had recalculated and altered the way they allowing for the leveraging of certain classes of stocks, many of which had been hit especially hard by the ongoing contraction. Bottom line: Adding insult to injury, our brokerage changed the rules, which reduced the amount we were allowed to borrow against, an amount already reduced by the contraction. Our maintenance margin requirement, with little notice, had been increased, and to avoid margin call, we'd be forced to add funds to our accounts or sell some positions as necessary. Fortunately for me, and my sad above-mentioned unfortunate experience, I never allowed greed to dominate my basically conservative nature, and therefore never allowed myself to leverage my account by more than 30%, which during this contraction had hit me especially hard. At the time I was extensively invested in the oil and shipping sectors. I pride myself for learning from experience, consequently, I still had ample excess liquidity not to be effected by the double whammy I'd been hit by. I wondered how many of my fellow investors had to scramble to keep their accounts in compliance.
Because this is not an advertisement for my broker, I will not mention its name; however, I moved my account there from my former bank related brokerage primarily because of its ridiculously high cost of margin, which at the time was 6%. My new and present broker charged 1.62% for the first $100,000 borrowed, 1.1% from $100,000 - 1,000,000, and .75% for amounts over a million dollars. Discovering that difference prompted the immediate move. Now, as a result of the Fed 1/4 point interest rate hike, the above rates have been adjusted upward accordingly. Consequently, I urge all investors who margin or are even considering margining, to call their brokers, if they have not already done so, and find out what their cost of borrowing actually is, and if you feel it's high, shop around for better rates.
Although this comparison of margin rates provided by The Margin Investor was compiled in 2013, it should be an eye-opening experience for those of you who utilize margin to enhance your portfolio's yield and earnings. Furthermore, if you are borrowing money at 6% and are making investments that yield you an average of 5%, I suggest you seriously re-evaluate your investment strategy.
To make my point, it might be wise to get a quick peek at the yearly interest rate you are paying these particular brokerages to borrow from $100,000 - $250,000. Remember, these are 2013 rates, which are probably higher today given the recent above-mentioned 1/4 point Fed hike. To name a few:
- Schwab (NYSE:SCHW) 6.83%
- Merrill Lynch, Bank of America (NYSE:BAC) 6.13%
- TD Ameritrade (NASDAQ:AMTD) 7.25%
- Interactive Brokers (NASDAQ:IBKR) 1.08%
- E*trade (NASDAQ:ETFC) 6.14%
- Wells Fargo (NYSE:WFC) 7.75%
- Vanguard (NYSEARCA:VCR) 6%
Let's explore the benefit of leverage by diving into the actual numbers of our hypothetical investment account; which for our purposes will be as follows:
- $100,000 of our own money invested.
- $50,000 Borrowed on margin. (not recommended)*
- 2% Margin interest/year.
- 8% approximate yield from investments.
* Only because don't recommend margining above 30%
The above is self-evident. The unlevered account earned a yield of 8% on its investments; consequently, earned $8,000 for an effective yield of 8%. In the leveraged account, our hypothetical investor borrowed $50,000, on margin, which allowed him to invest a total of $150,000. His borrowed funds cost him 2% interest/year. He also earned 8% on his invested capital, which earned him $12,000 - $1,000 (interest expense) = $11,000 in profit, or an effective 11% yield initial $100,000 investment.
Properly applied, leverage can enhance your portfolio yield; improperly, and approached without sufficient research and caution can, either cost you incrementally in percentage points, or catastrophically, if and when the market turns against you and you have insufficient resources to cover your broker's margin requirements, which might be changed with little notice. Leverage, yes, excessive leverage a big no, no.
And before you even decide on which brokerage you will trade with, I urge that you learn which offers the lowest margin rates, and by-the-way, the lowest fees and commissions per trade and simply for the privileged of using their platform.
Furthermore, should you decide to margin, you must realize the potential volatility of the positions in your portfolio should be assessed carefully before you determine just how a percent you want to go on margin. As I did, you might want to invest in oil wildcatters. If so, be prepared to keep your margin at a low level. Alternatively, if your portfolio is conservatively populated with stogy, low risk positions, you might allow yourself to leverage at a greater percent.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: An important part of trading is the proper application and use of leverage and margin. Unfortunately, it is too often used carelessly and without forethought and adequate research, which too often results in ongoing, barely noticed incremental losses or catastrophic losses as a result of a market correction or simply the individual investor's unwise decisions. Beware, leverage will magnify the losses as well as the gains.