With all the recent turmoil in the stock markets over the past few days I thought it might be interesting to try and document/explain what it means for the average investor to buy securities on margin and what the consequences might be when the market goes through some wild gyrations.

I’m going to try and keep this simple and not get into margin interest rates or what happens to dividends when a stock is purchased on margin. Not only is it sorta boring but I’m not bright enough or qualified enough to explain those things in terms the average person can understand. If you want to know all the ins and outs, I suggest you contact your investment advisor/broker for the gory details.

On with the show…

Let’s say that you got a hot tip from one of your drinking buddies that the price of Up In Smoke Inc was getting ready to go through roof over the next month or so. You, being the savvy investor would like to buy 100 shares at the current price of $40.00. The only problem is that you only have $2000.00 lying around and in order to complete your purchase you’d need to come up with another $2000.00

Well, if you meet certain qualifications your broker will allow you to buy the 100 shares and lend you the $2000.00 difference. The shares that were purchased in Up In Smoke Inc will be held at the brokerage firm as collateral against the loan.

So, now you’re the proud owner of 100 shares of Up In Smoke Inc and you can sit back a drink a brandy or two and smoke some expensive cigars waiting for the price to go up so you can turn a profit.

Let’s look at some of the potential outcomes.

Let’s say your buddy was right and the price jumps to $50.00 a share. You immediately get on the horn to your broker and request that they sell your position. The total proceeds from the sale amount to $5000.00. What happens next is pretty good for you. The transaction would unwind as follows. You use the $5000.00 from the sale to pay off the $2000.00 the broker lent you. That leaves you with $3000.00. Considering that you only put up $2000.00 to begin with you’ve made a profit of $1000.00. I’ll take a 50% return any time.

Think of it this way. If you had used your own money ($4000.00) to complete the initial purchase you’d still make a $1000.00 profit but your return would “only” be 25%.

It’s at this time you break out the bubbly and take your significant other out for a night on the town.

Now for the other side of the coin…

Let’s say your buddy was wrong on Up In Smoke Inc and it tanks. In fact, it tanks so badly that the price drops from the $40.00 to $28.00. The original investment of $4000.00 is now worth a paltry $2800.00. When you factor in that you’re already in the broker’s pocket for the $2000.00 they fronted you to make the purchase in the first place your portion is now $800.00. This is a net loss of $1200.00.

It’s at this point that you’ll most assuredly get a friendly phone call from your broker explaining your options.

Option 1 – Show me the money!

In this case, because the market value of your stock is $2,800.00 but the margin loan is still at $2,000.00 your broker is gonna be a bit worried. They’re gonna ask you to pony up either more cash or securities to be used as collateral and restore it to a 50% balance. Right now, you’re in the hole to the tune of about 71% of the original loan. That would be the $2000.00 divided by the current market value of $2800.00.

So you pawn grandma’s wedding ring and make your way to the broker and deposit the cash to make up for the difference and all is hunky dory. You say your prayers and hope that the market for Up In Smoke Inc reverses its downward spiral.

Option 2 - You’re fucked!

Let’s say you already hocked grandma’s wedding ring and have nothing left to sell or pawn to come up with the additional collateral. It’s at this point that the broker, who was so accommodating when you first started this little adventure, turns into a modern day version of Simon Legree and sells the 100 shares of Up In Smoke Inc out from under you with the total proceeds of the sale equal to $2800.00. Out of that $2800.00 he pays himself back the $2000.00 he fronted you leaving with $800.00 You my friend, are now staring at a 60% loss on your original $2000.00

It’s at this point where you stock up on cheap booze and commence to start drowning your sorrows.

In the end, any kind of investing, especially when you’re using somebody else’s money, is not for the squeamish. There’s an old saying that goes something along the lines of “The greater the risk, the greater the rewards”.

That’s only true if the risk pans out in the first place.

As always, Caveat Emptor!

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