 Personal Finance PowerPoint Presentation, Bind On Margin. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia, Bind On Margin, which you can find online. Take a look at the references, resources, continue your research from there. This is by James Chen, updated April 21, 2021 in prior presentations. We've been looking at investment goals, strategies, tools, keeping in mind the two major categories of investments, that being the fixed income, typically the bonds and the equities, typically the common stock. Also keeping in mind our investment tools, which could include things like mutual funds and ETFs helping us to pool our investments together for diversification. Strategies for investing might differ then if investing in individual stocks, in which case we might be drilling down on the financial statements of those individual stocks doing racial analysis and trend analysis on them. Keeping that in mind, we're now asking, what is buying on margin? Buying on margin occurs when an investor buys an asset or borrowing the balance from a bank or broker. So when we're going to be buying on margin, we're buying basically with not our money, not with cash for example, but we're borrowing funds in some way to do it. We're basically leveraging the purchase, which could have some benefits, but of course could have some drawbacks, possible for gains with regards to buying on margin, but also possible to amplify losses or downsides. We've got to be very careful with it. So buying on margin refers to the initial payment made to the broker for the asset. For example, 10% down and 90% financed. So you can kind of understand these terms with regards to a lot of people's biggest investment, which is usually like their home, which in that case you're investing in the home. Obviously when we buy a home for example, we're purchasing it for our own use often times, but we could also think about it as an investment. Oftentimes you might be thinking you put, you know, the 20% down and you financed the rest of it. In that case, generally because most people can't afford the full purchase of the home, but you have a similar kind of scenario here from an investment standpoint. So if the home goes up in value, then of course you have a huge benefit because you were able to not only put the money that you could afford the cash in place, but you also financed it so that you kind of got a return on investments that you didn't really have in the first place, which could be great. It can amplify your gains, but on the flip side, if the home goes down in value, then it can amplify the losses when you have this leverage component in place. So the investor uses the marginable securities on their broker account as collateral. So the security itself then being the collateral in a similar way is kind of like the home, of course, would be the collateral in the purchase of a home type of situation. Collateral meaning that if you default on paying back then the loan, then the investment is the collateral on that to secure the person that's giving the loan, the financial institution giving the loan. The buying power an investor has in their brokerage account reflects the total dollar amount of purchases they can make with any margin capacity. Short sellers of stock use margin to trade shares. Understanding buying on margin, the Federal Reserve Board sets the margins securities. So as of 2019, the board requires an investor to fund at least 50% of a securities purchase price with cash. The investor may borrow the remaining 50% from a broker or a dealer. As with any loan, when an investor buys securities on margin, they must eventually pay back the money borrowed plus interest, which varies by brokerage firm on a given loan amount. Monthly interest on the principal is charged to an investor's brokerage account. Essentially buying on margin implies an individual is investing with borrowed money. So again, you might think of that as kind of counterproductive because we face a similar kind of situation when we think about investing in general that we've talked about in prior presentations, question being should I pay down the debt that I currently have and or should I invest at this point in time? Obviously if you have debt that has high rates that you're paying like credit card payments that are charging high rates of interest, then it might be more beneficial to pay down the debt. But if you have some debt that has low amounts of interest possibly due to import tax related to it or tax benefits the home mortgage for example, then you might say I'm going to keep the debt for example on that to keep paying that down and possibly put then the investments into the market thinking that you might be receiving a gain higher than what you can pay off on the loan. When you're buying on margin, you can have a kind of a similar kind of thought process if you think the investment is going to go up in the future. If you could predict the future and say I know that this investment is going to increase in value greatly, then you would like to put as much money on it as possible generally and if you could borrow the money to do that if it was a guaranteed type of thing and then get the return on the investment clearing or getting an amount over and above the interest, the rent that you have to pay on the loan, then that would be a beneficial thing but obviously nothing's guaranteed in the future. So although there are benefits, the practice is thus risky for the investor with limited funds. So how buying on margin works? To see how buying on margin works, we are going to simplify the process by taking out the monthly interest costs. So let's first think about it without the interest. The interest of course is the rent on the borrowing of the money. So although interest does impact returns and losses, it is not as significant as the margin principle itself. Consider an investor who purchases 100 shares of company XYZ stock at $100 per share. The investor funds half the purchase price with their own money and buys the other half on margin bringing the initial cash outlight to $5,000. So one year later, the share price rises to $200. So that's great because now we put our investment in place and the stock rose in value. So that was like a good play on our part. The investor sells the shares for $20,000 and pays back the brokerage of the $5,000 borrowed for the initial investment. Ultimately in this case, the investor triples their money making $15,000 on a $5,000 investment. Again, this is kind of similar to what you might see in like a home situation where people's house goes up in value and it's like, wow, that was amazing, you know, return that they got on it. Well, that's because they made like $100,000 investment on $20,000, right? Because they only put $20,000 down and the market went up and you had a whole lot more money than you actually owned investing, which amplified the return. Now, again, of course, if it went down, if the market went down, then it could amplify the losses on the downside. So there's risk involved in that as well. Many people could argue on the housing market, well, houses don't go down as often or so on and so forth, but they do sometimes and when you're completely leveraged or overleveraged, then there could be a problem. So there's a question of what's going to be the optimal leverage amount to work with, for example. So if the investor had purchased the same number of shares using their own money, they would only have a double their investment from $5,000 to $10,000. Now, consider that instead of doubling after a year, the share price falls by $50, so that's not good for the leverage. So the investor sells at a loss and receives $5,000. Since this equals the amount owed to the bank, the investor loses 100% of their investment. If the investor had not used margin for the initial investment, the investor would still have lost money, but they would only have lost 50% of their investment, $2,500 instead of $5,000. So you can see how the risk and reward kind of pays off on it. People can get overextended when they get into this leverage kind of situation, as you can see with kind of flipping situations in the homes on the housing market as well. When things are going good, people are rolling high and highly leveraged, but when there is a drawback in the market or when things go bad, if you're not careful, then you can get a severe hit that could affect the cash flow greatly, so you want to be careful. So how to buy on margin? The broker sets the minimum or initial margin and the maintenance margin that must exist in the account before the investor can begin buying on margin. The amount is based largely on the investor's credit worthiness. A maintenance margin is required of the broker, which is a minimum balance that must be retained in the investor's brokerage account. So you've got to have some money in there. Suppose an investor deposits $15,000 and the maintenance margin is 50% or $7,500. If the investor's equity dips below $7,500, the investor may receive a margin call. At this point, the investor is required by the broker to deposit funds to bring the balance in the account to the required maintenance margin. The investor can deposit cash or sell securities purchased with borrowed funds. If the investor does not comply, the broker may sell off the investments held by the investor and restore the maintenance margin. Who should buy on margin? Generally speaking, buying on margin is not for beginners. So typically if you're just putting money in for retirement to the old 401k plan or the IRA, then buying on margin usually isn't a strategy you want to be taking, because usually there you are a long-term investor typically and you're trying to get value through a long-term growth in the market. So it requires a certain amount of risk tolerance and any trade using margin needs to be closely monitored. So clearly when you buy on margin and you've got that leverage in place, then you're going to be a lot more active in the investment process than generally if you're more of a passive investor, say investing for a long-term plan like retirement. Seeing a start portfolio lose and gain value over time is often stressful enough for people without the added leverage. So notice again, a normal investor long-term time horizon is probably best strategy to put the money in there with a secure plan and then not be stressed out on the day-to-day fluctuations, because if you're looking at the day-to-day fluctuations, you're not really a long-term investor there, you're looking at shorter time horizons and if you're doing that, you want to make sure that you're doing that mindfully and thinking about gains and losses during that timeframe that you're focused in on. So furthermore, the high potential for loss during a stock market crash makes buying on margin particularly risky for even the most experienced investor. However, some types of trading such as commodity futures trading are almost always purchased using margin while other securities such as options contracts have traditionally been purchased using all cash. Buyers of options can now buy equity options and equity index options on margin provided the option has more than nine months until expiration. The initial maintenance margin requirement is 75% of the cost market value of a listed long-term equity or equity index put or call option. For most individual investors primarily focused on stocks and bonds, buying on margin introduces an unnecessary level of risk.