Margin is the term used to describe a type of account in which you are approved to borrow up to two times the available equity in your account.

 

The cash account: If you open an account at any brokerage firm it will be a cash account unless you sign the forms to change it into a margin account.

 

Understanding the margin account: The Federal Reserve determines the margin rate, which is 50% at the present time. You are permitted to borrow up to 50% of a stock purchase. For example, if you have $15,000 in cash you can buy up to twice that or $30,000 in stock. Your buying power is doubled.

 

There are Advantages to using margin and there are disadvantages. We will explore both in detail in an effort to keep you out of trouble.

 

Leverage for daytrading: The higher priced stocks generally have larger price swings than lower priced stocks. Therefore, higher priced stocks are more likely to generate larger profits. For example, if a $20 stock moves 10 percent, it would move only $2 in a day, but if a $200 stock moves 10 percent it would move $20 in one day. So, purchasing only 100 shares of each stock would have a profit potential of either $200 or $2000 respectively.

With a $15,000 cash account, you could buy 100 shares of a $150 stock, but the same $15,000 in a margin account would enable you to buy 100 shares of a $300 stock. This is true leverage. And, it costs you nothing to use the margin as long as you sell the margined stock by the end of the day. If you hold the margined stock overnight you will be charged interest.

 

Increased risk for holding overnight: Holding margined stock over night will cost you about 10% yearly interest. Consider the additional risk holding overnight and what you get for it. Suppose at market close you were to buy 500 shares of Intel at a price of $60. The next morning the stock opens at $61. The risk of holding overnight was rewarded with a $1 per share profit. But, what do you risk for that $1 profit. Suppose overnight the price dropped $10 instead. You are now an investor with the option to sell the stock at $50 per share and take a $5000 loss or to hold the stock until it comes back up to $60. Most people would hold the stock of a solid company like Intel. So, you hold the stock. Two weeks pass and the price has gone down to 35 and is finally rebounding. Assume you used $15,000 in margin to buy the stock. The leverage has worked against you because you are now paying interest on the margined amount and you have no idea how long you will need to continue.

 

Holding over night using cash and no margin would enable you to stay in that position for as long as necessary with no additional cost. In other words, if you only bought 250 shares to hold over night then margin interest and the possibility of a margin call would not be involved.

 

Margin calls: A margin call is a request from your account holder (broker) for more money to be added to your account. There are different types of margin calls, the REG-T or Fed call, and the minimum maintenance call. When a REG-T call is triggered, you must add additional funds to your account or your account will be restricted. To satisfy a minimum maintenance call you can add funds or sell stock that is in your account.

 

How a margin call can wipe you out! In March and April of 2000 the market spiraled downward causing some investors to lose ALL of their money and then some. How can this happen? It begins with greed. I'll use an example to explain. Suppose Fred began buying stocks in the middle of 1999 when the NASDAQ was in an upswing. The market would dip and Fred would buy more stock because, in an up trending market, the stock price makes new highs after each pull back.

Fred has a $20,000 cash account with his $20,000 fully invested and, it is now worth $40,000. To increase his leverage he changed his account to a margin account to increase his buying power allowing him to acquire more stock. Fred is now borrowing money (margin) to buy stock. Fred's account now has a market value of $70,000 and he is paying interest on the debit balance. He is very happy when his monthly statement arrives because, on paper, his account value keeps rising. To take further advantage of the bull market Fred borrows money on his house and from his family and puts the borrowed $50,000 into the market. His account is eventually worth $150,000.

Fred hears on the news that there is no end in site to the bull market. He begins buying expensive toys. Why not? His $70,000 investment is now worth $150,000 and growing. He is $80,000 ahead. The market makes another dip and Fred buys another $5000 in stock , but this time instead of the market going higher it makes a lower high. Fred thinks, "Well, it will come back up just like it has been doing in the past," only this time the market goes through a massive sell off. Not wanting to take a big loss, Fred rationalizes that the market always comes back, so he hangs in there, but the market keeps dropping and his account is now less than half of what it was. In fact, Fred would lose $10,000 if he were to sell out now, so he hangs in longer. The market continues to drop to new lows causing his account to fall below the minimum maintenance requirement triggering a margin call. Fred must sell all his stock and also come up with an additional $10,000 just to pay his margin call. Here's the really bad part. Fred has no money left. Every penny was pumped into the market. He now has no choice but to sell his stocks at a loss and pay off the margin call with the proceeds. Unfortunately, he must borrow an additional $10,000 on his credit card because the stocks sold in his account did not cover the margin debt.

This is a common scenario for investors that used margin over night and were caught in the March-April sell off. Now, Fred has no equity in his house, his bank account is empty and he must work overtime to pay off his credit cards.

 

The Lesson: Use margin during the day to increase profit potential, but use only the cash value in your margin account if you are going to hold stocks over night, so you can avoid a catastrophic loss during a market sell off.

 

Short selling: In addition to leverage, another advantage of the margin account is being able to sell a stock short. Selling a stock short can not be done in a cash account, only a margin account. Selling short enables a trader to profit when stock prices decline.

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The following paragraph and slide are from The September newsletter!

The slide below shows the trend from the market high of around 5000. Notice how the market trend can shift.

NASDAQ Comp. as of Sept. 1,2000. The monthly chart below shows how the month of August hit the down trend line and closed on the high of the month. September 1st broke through the trend line creating a higher high for the candlestick starting in September. This is a positive sign for the continuation of a monthly up trend. Also, notice how the low of August was a higher low staying in an up trend. The market is still trending upward towards its old high of 5000.

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October 2nd As you can see below, September sold off all the way to the lower trend line. October began by gapping up, but then selling off through the trend line.

 

October 12th The sell off is heading for the support. When it hits the support line there is a 50/50 chance for a bounce to the up side or a continuation of the bear market.

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November 3rd There was a powerful bounce off the support. This created a double bottom. The November candle is now touching our old trend line, but the old trend line should be adjusted to touch the top of the September candle. That would move it a little to the right.

If you Can't immediately understand the various principles when looking at these charts, it is suggested that you enter a training program (such as ours, of course) or read the necessary books to develop these skills. Poor chart reading skills are similar to flying a plane with blindfolds on. Remember, your money is counting on you!!!