 Hello and welcome to the session. This is Professor Farhad in which we would look at buying on margin a topic that's covered in an essentials Or principles of investment graduate or undergraduate as always I would like to remind you to connect with me on LinkedIn if you haven't done so YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance as well as Excel tutorial. If you like my lectures Please like them, share them, put them in playlists if they benefit you It means they might benefit other people connect with me on Instagram on my website farhatlatchers.com You will find additional resources to complement and supplement Your accounting as well as your finance education your CPA and CFA exam So if you're looking to add points to your exam professional certification check out my website So buying on margin what is buying on margin? Simply put when you want to buy stocks or securities from your From your broker your broker will give you more money. Well, that sounds good. Can you take that money? Not really you could just buy with it Okay, so when purchasing securities investors have have easy access to a secured debt Financing called brokers call loans. What does that mean? It means you can borrow money against Against your securities to buy more securities now I would rephrase Sometime you can't take it out in cash, but that's not what we are talking about here because I just said you can't take it out And cash you can so when you take advantage of this loan, it's called buying on margin It means you are using the money to buy on margin That's simply what it is you put $5,000 in the bank The bank would say you put $5,000 We're gonna put an additional $5,000 in your bank account and now you have so this is yours and this is the broker But it's under your control $10,000 you're purchasing is $10,000 so the margin in the account is the portion of the purchase Contributed by the investor. So this is the margin the first 5,000 is called the margin The second 5,000 is borrowed borrowed means it's alone and guess what when somebody gives you money They expect you to pay interest so you have to pay interest on that loan So that's another source of revenue for the broker. So the broker will borrow the money from banks at The call money rate remember we talked about the call money rate There's a there's a rate for that to finance these purchases and they charge you interest Obviously because they borrowed the money plus a service charge So if they borrowed the money at 3% they might lend it to you at 6% or 5% So they will obviously they'll have to pay back 3 and they will pocket the difference All securities purchase on margin must be maintained with the brokerage firm in the street name Think about it. You're not gonna go to mirror Lynch buy stocks on margin Okay, use their money then transfer those stocks to your fidelity account. That's not gonna be acceptable Okay, because the money is you bought the shares on margin Now if you have shares at mirror Lynch Securities at mirror Lynch and you would like to transfer them to fidelity. That's okay as long as you did not buy Then on margin why because the security is that you have at mirror Lynch? They are they are a collateral for the margin So if you are taken away your money the collateral is gone So what they do they sell the shares then they give you your portion Which is your margin portion that you can do whatever you want with it Okay, the board of governors of the federal reserve system limit the extent to which stock purchases can be financed using Margin loan simply put here's what the here's what are the rules right now the current initial Margin requirement is 50% Meaning that at least 50% of the purchase must be paid in for cash when you buy something you have to pay 50% Now that's not true for all securities for certain securities You have to but you have to pay more of the securities are risky But generally speaking you have to pay at least 50% from your own money. Okay, and the broker will finance the other 50 The best way to illustrate this is to to work an example. Just give me a moment There's something called the percentage margin you have to know what is the percentage margin is the ratios It's like a ratio means it's it's one number divided by the other of the net worth or equity Net worth or equity I'm just gonna use equity because you should be familiar with the term equity and I will define equity in a moment divided by or the equity of the account to the Market value of the securities. How much do you have equity divided by the? market Value that's basically what it is equity divided by the market value and so what what is equity? You know what equity is equity is assets Minus liabilities What is your equity if you have $10,000 in your bank account and you have $3,000 in loans You have a net equity of 7000. That's your equity or your net worth So that's what equity is assets minus liabilities. Hopefully, you know this suppose an investor initially pays $6,000 Pays $6,000 toward the purchase of a $10,000 worth of stocks. So they bought 100 year each year is worth 100 they contributed 6,000 they borrowed the remaining. What does that mean? Well, what do they have in their hands? Well, they have 100 shares Times $100 those are the assets. They have $10,000 worth of assets of which of these of which $4,000 are liabilities or loans Well, what's the net worth the net worth is? $6,000 if I ask you what is the percentage margin? Well, it's the this is the equity Assets minus liability the formula is equity divided by assets the assets are $10,000. So the percentage margin is 60% so this is how it works So from a balance sheet prospective assets and liabilities and hopefully you are familiar with that if not you need to go to my Accounting lectures on my website or on my YouTube you have $10,000 worth of assets worth of stocks You have loans from the broker $4,000 $10,000 minus 4 gives you equity of $6,000 and this is basically how we compute the initial percentage Martian 60% so you you come up with more than 50 you paid 60% okay, but you have to pay at least 50 Now what happened if the price declined to $70 so what happened the price was 100 initially the price declined to 70 well if the price declined to 70 the value of your stocks are 7,000 Your loan will stay the same. Well, guess what if your stocks went on 3,000 Your account your equity will go down by 3,000 because 7,000 of assets should equal 7,000 of liabilities in equity Okay, so this is what would happen. So your your value of the stock is 7,000 This will stay the same and your equity will go down because what happened is you lost 3,000 now What would happen the assets and the account fall by a full percentage in the stock value? So so that's the equity. So now if you want to calculate your percentage Martian It's your net value, which is your equity of 3,000 divided by the market value of your stocks Which are 7,000 now your percentage Martian is 43% your Martian is 43 so it was 60 now. It's down to 43 Didn't we say that the Federal Reserve Bank said there's a 50% that's initially when you buy it initially You have to put up 50% now it fell below 50% so now we need to know what happened if it keeps on falling Let's think about this for a moment. What happened if your stock value goes down to $4,000 so if the value of the stock keeps goes down to 40 and your value is 4,000 4,000 your broke your loan is 4,000 and your equity is zero Basically, you are wiped out and that's under those circumstances Do you think the broker would allow you to get to get that here? And the answer is no because once you fall below 4,000 the owner equity becomes negative simply put once you go below 4,000 if the if the rate if you have 3,500 then you have negative 500 of equity and this is taken away from the broker Do you think the broker is gonna let you do that? Absolutely not Okay, so the value of the stock is no longer sufficient to cover the loan from the broker They don't wait all the way until you got the 4,000 what they do to guard against that possibility because remember stock drop down Very quickly once the stock starting to drop. They don't wait until you are wiped out You are down to 4,000 because after 4,000 now you are losing their money what they do is If the percentage margin falls below the maintenance level a certain level called the maintenance level once it falls below a certain level and Each firm will have a different maintenance for different stocks. The broker will issue a margin call So once it falls below that certain percentage you'll tell you look you have two options You have to give us more cash or we're gonna sell your position liquidate your position Which required the investor to add more cash or the securities or Securities you add more cash or stocks so you can transfer stocks from another account Or you have to sell your stock and turn them into cash and give them back their money Okay, so what happened if you don't act that when you know, I don't have money to pay I don't want to sell well the broker will sell your stocks from the account to pay off enough of the loan to restore the Percentage to the maintenance level because they said look we have a maintenance level. We cannot fall below it Once you fall below it, we need to protect ourselves. You either give us money give us stocks additional stocks from somewhere Or we're gonna sell if you don't do that. Okay, so let's take a look at how we compute this Suppose the the maintenance margin is 30% for at that firm for that stock How far could the stock fall below the investor would get a margin call margin call is simply literally a call They will call you or they will send you an email now They they can they call it or they send you an email before they used to call you especially if your account is large Now they would send you an email and they would still send you a letter But the letter it's too late sometime by the time you get the letter So here's how we compute this let P the price of the stock the value of the investor shares and is then is 100 times P so P is the price of the stock because we want to look for the price of the stock So 100 P is the 100 shares times the price and the equity in the account is 100 P minus the loan So this is the equity in the account 100 shares times the price. We don't know minus the loan. So this is the equity. This is the Equity the percentage margin The percentage margin is the equity divided by the price of the stock 100 times P And we're gonna set this equal to point three So what we do now we just solve for the equation. How do we hopefully, you know how to solve for the equation? We cross multiply we say point three times 100 P equal to 100 P minus 4,000 point three times 100 P is 30 P equal to 100 P minus 4,000 basically we just you know Let's subtract 30 Yeah, let's subtract 30 P from each side what we're gonna end up with is negative 70 P equal to negative 4,000 just multiply by negative negative one 75 P equal to 4,000 Sorry, not 75 70 P 70 P equal to 4,000 P equal to 4,000 divided by 70 the price is 57 point 14 So simply put once the price of the stock gets to 57 point 14 You're gonna get a phone call. Okay, because remember to come down to 40 The price has to go down to 40 They don't wait until you get to 40 at 70 at $57 and 14 cent you'll get a call Look, you either come up with more money to bring it above 30 or we're gonna sell your stock Simply put we're gonna sell your stock. Okay now Suppose that the maintenance margin is 40 percent how far can the Can the stock price drop before the investor gets a margin call? Well, what does that mean? It means you have 100 shares Times the price. We don't know what the price is minus 4,000 That's your that's your equity and you're gonna divide this equity by your the value of the stocks 100 times P Equal to point 4 now again you cross multiply Point 4 times 100 P equal to 40 Basically what it gonna boils down to is P equal to 4,000 divided by 60 and this should equal 4,000 divided by 60 at 66.67 if the if the margin is 40% By the time you get the 60 but once the price drops to 66.67 you're gonna get a phone call or an email or notification Look, you know, you you are at the maintenance level. Give us money Send us money. Give us additional stocks or we're gonna sell enough shares We're gonna sell enough of these 100 shares. So where this becomes point four or above So this is how it works. Okay. Now. Why do people buy on March? And so why do people buy on March and obviously it's agreed because you if you're bullish about something if you're bullish means You think it's gonna go up. You just you don't only use your money You borrow more money because you want to increase your return You wish to invest an amount greater than the amount that you have It's basically greed you achieve a greater upside potential. But look come here comes the risk They're also you are faced with a greater downside risk because you're not only losing your money You're losing your money and the firm's money Suppose an investor is bullish on think or top think or start which is selling for $100 per share an investor with $10,000 expect to Expect the expect the price to rose by 30% So if you invest $10,000 the price increased by 30% you will get 30% return Assume you're confident about this. What you do is, you know what? I'm not gonna only invest 10,000 I'm gonna borrow $10,000 to invest in that stock. So here's what happened. You did not only have 10,000 Now you have 20,000 to invest now you have 20,000 because you borrowed an additional 10,000 you can buy 2,000 share assuming an interest rate on the margin is 9% So the money that you borrowed You have to pay 9% what will be the investor's rate of return again ignoring dividend if the stock goes up to 30% By the year end. So you held the stock for a for a year. It went up 30% so here's what's gonna happen if it went up 30% The 200 shares will be worth at 26,000 Because they went up 30% 3,000 for each 10,000 Now here's what's gonna happen. You're gonna pay off 10,900 You're gonna have to give back the original the 10,000 dollar You have to give it back plus you have to give that you have to give back 10,000 times 0.09 you have to pay interest of 900 so you have to pay back 10,900 and And you're gonna leave with you 15,100 which is the 26,000 the value of the stock minus what you paid back So the rate of return in this situation you made 51% 51% but that's pretty risky. That's pretty risky because let me show you what happened if the stocks does not move and if the stocks Drops so let's see this example again on an excel sheet. So this way I can break everything for you little bit more in detail So let's take a look at these figures a little bit more in detail So you understand what's going on here Initially, you had $10,000 in your pocket you decided to borrow an additional 10,000 as a result you have $20,000 ready to be invested that $20,000 grew to be 26,000 because it grew 30% here's what's gonna happen you You are up to you you're up to 36% 30% at 26,000 you have to pay back the $10,000 that you borrowed And you have to pay back the interest remember the interest It's going to be $900, which is because you borrowed $10,000 times 9% so you have to pay back in total 10,900 so if you pay back in total 10,900 what you're gonna be left with is left with is 15,100 you left with 60 15,100 and your original money is 10,000 so let's see how this plays out So you have to pay back almost so you have to pay back You have to pay back an interest and principle 10,900 your interest is 900 therefore your net return is 15,100 so this is where the 15,100 came from so a fifth. I'm sorry 5,100 is your net return because You know you made 15,100 from from 10,000 therefore this is your net return if you take your net return divided by the original amount You made 51% so this is another way to see how you made 51% Let's take a look at this same example assuming your stock did not move so again you have $10,000 You borrowed an additional $10,000 the stock went nowhere in the scenario so the it end up to be 20,000 you have to pay back 10,900 so what you did because you had to pay in an additional 900 an interest You lost $900 you lost $900 therefore your rate of return is 9 negative 9% although the stock did not go up or down you still lost The money that you invested for a year remember this example assuming you waited for a full year now Let's see what happened if you if the stock went down 30% you have 10,000 initially you borrowed another 10,000 Now you have 20,000 to invest the stock went down The stock went down 30% now you have now you have $14,000 you have to pay back 10,900 Remember the interest is $900 now your net return is 6,900 so how do they come up with the net return 6,900 remember for each 10,000 you lost 30% so you lost 3,000 on your 10,000 you lost 3,000 on the brokers 10,000 that's 6,000 then you have to pay interest of 900 Your total losses are 6,900 your total losses are 6,900 From an investment that you originally have 6,000 10,000 now your return is negative Which is negative 69 notice if you lose If you lose you would lose more than what if you want so buying on margin is a risky risky Business that's the point that I'm that's the point that I'm trying to make now That's risky and what else is risky is short sales A topic that we will discuss next on the next session would look at short sales short sales as always Please like this recording share it put it in playlist and don't forget to visit my website farhat lectures calm If you want additional resources good luck study hard and stay safe