For investors interested in taking on additional risk, there are two advanced trading techniques, and both involve using credit: buying stocks on margin and selling short. Buying stocks on margin involves using a line of credit from a stockbroker, thereby enabling the investor to effectively control many more shares with a small amount of cash. Investors who sell shares of stock short are actually selling shares they do not own.
Margin Trading Is Buying Stocks on Credit
Some investors open a margin account with a brokerage firm in addition to their cash account so they can buy securities using credit. Opening a margin account requires making a substantial deposit of cash or securities ($2000 or more) and permits the purchase of other securities using credit granted by the brokerage firm. Using a margin account to purchase securities, or margin buying, allows the investor to apply leverage that magnifies returns. In essence, the investor borrows money from the brokerage firm to buy more stocks and bonds than would be possible with his or her available cash. Both brokerage firms and the Federal Reserve Board regulate the use of credit to buy securities. The margin rate is the percentage of the value (or equity) in an investment that is not borrowed. In recent years, it has ranged from 25 to 40 percent. Thus, if the margin rate is 40 percent, you can buy securities by putting up only 40 percent of the total price and borrowing the remainder from the brokerage firm. The securities purchased, as well as other securities in the margin account, are used as collateral. Margin lending is financed at competitive interest rates.
Buying on Margin Can Increase Returns. Buying on margin is commonly used to increase the individual’s return on investment. For example, assume that Greenfield Computer Company common stock is selling for $80 per share. You want to buy 100 shares, requiring a total expenditure of $8000. Using your margin account, you will make a cash payment of $3200 (0.40 X $8000), with the brokerage firm lending you the difference of $4800 ($8000 - $3200). For the sake of simplicity, we will omit commissions from this example and assume that the brokerage firm lends the funds at 10 percent interest. Thus, your equity (market value minus amount borrowed) in the investment is $3200. If, as illustrated in Table 14.2, the price of Greenfield stock increases from $80 to $92 at the end of a year, you can sell your investment for proceeds of $9200, minus the amount invested ($3200), the amount borrowed ($4800), and the cost of borrowing ($4800 0.10 $480), for a return of $720. Because you invested equity of only $3200 to obtain a profit of $720, you have earned a return of 22.5 percent ($720 $3200). If you had put up the entire $8000 and not bought on margin, your return on investment would have been only 15 percent ($9200 - $8000 = $1200; $1200 + $8000 = 0.15). In this way, you can use credit to increase the rate of return on your own investment. Those with an aggressive investment philosophy might buy on margin because it gives them the opportunity to obtain a higher rate of return.
Margin Trading Is Buying Stocks on Credit
Some investors open a margin account with a brokerage firm in addition to their cash account so they can buy securities using credit. Opening a margin account requires making a substantial deposit of cash or securities ($2000 or more) and permits the purchase of other securities using credit granted by the brokerage firm. Using a margin account to purchase securities, or margin buying, allows the investor to apply leverage that magnifies returns. In essence, the investor borrows money from the brokerage firm to buy more stocks and bonds than would be possible with his or her available cash. Both brokerage firms and the Federal Reserve Board regulate the use of credit to buy securities. The margin rate is the percentage of the value (or equity) in an investment that is not borrowed. In recent years, it has ranged from 25 to 40 percent. Thus, if the margin rate is 40 percent, you can buy securities by putting up only 40 percent of the total price and borrowing the remainder from the brokerage firm. The securities purchased, as well as other securities in the margin account, are used as collateral. Margin lending is financed at competitive interest rates.
Buying on Margin Can Increase Returns. Buying on margin is commonly used to increase the individual’s return on investment. For example, assume that Greenfield Computer Company common stock is selling for $80 per share. You want to buy 100 shares, requiring a total expenditure of $8000. Using your margin account, you will make a cash payment of $3200 (0.40 X $8000), with the brokerage firm lending you the difference of $4800 ($8000 - $3200). For the sake of simplicity, we will omit commissions from this example and assume that the brokerage firm lends the funds at 10 percent interest. Thus, your equity (market value minus amount borrowed) in the investment is $3200. If, as illustrated in Table 14.2, the price of Greenfield stock increases from $80 to $92 at the end of a year, you can sell your investment for proceeds of $9200, minus the amount invested ($3200), the amount borrowed ($4800), and the cost of borrowing ($4800 0.10 $480), for a return of $720. Because you invested equity of only $3200 to obtain a profit of $720, you have earned a return of 22.5 percent ($720 $3200). If you had put up the entire $8000 and not bought on margin, your return on investment would have been only 15 percent ($9200 - $8000 = $1200; $1200 + $8000 = 0.15). In this way, you can use credit to increase the rate of return on your own investment. Those with an aggressive investment philosophy might buy on margin because it gives them the opportunity to obtain a higher rate of return.
Buying on Margin Can Increase Losses. If the price of a security bought on margin declines, however, leverage can work against you, as Table 14.2 also illustrates. For example, if the price of the Greenfield stock bought at $80 dropped to $70 after a year, you would lose $10 per share on the 100 shares, for a total loss of $1000. Your proceeds from selling the stock would be only $7000. If you bought the stock on 40 percent margin, these proceeds are offset by the cost of the investment ($3200), the margin loan from the broker ($4800), and interest on the loan ($480), for a total deduction of $8480 and a net loss of $1480 ($7000 - $8480). Thus, a loss of $1480 on an investment of $3200 is a negative return of 46.25 percent ( $1480 + $3200). The same $10 loss per share (from a price of $80 to $70 per share) would have been a negative loss of only 12.5 percent if the stocks were not bought on margin ($7000 - $8000 = $1000; $1000 $8000 = 0.125). Similarly, the example cited in Table 14.2 shows the magnitude of the loss due to a $20 decline in value as a negative return of 77.5 percent, compared with a loss of only 25 percent if the investor had not bought on margin.
A Margin Call Makes Matters Even Worse. When the price of a stock declines to the point where the investor’s equity is less than the required percentage, the brokerage firm will make a telephone call to the investor. A representative of the firm will tell the investor to immediately either put up more collateral (money or other stocks) or face having the investment liquidated. This procedure is known as a margin call. If the investor fails to put up the additional cash or securities to maintain a required level of equity in the margin account, the broker will sell the securities at the market price, resulting in a sharp financial loss to the investor. The investor is required to repay the broker for any losses. The margin call concept protects the broker that has loaned money on securities.
A Margin Call Makes Matters Even Worse. When the price of a stock declines to the point where the investor’s equity is less than the required percentage, the brokerage firm will make a telephone call to the investor. A representative of the firm will tell the investor to immediately either put up more collateral (money or other stocks) or face having the investment liquidated. This procedure is known as a margin call. If the investor fails to put up the additional cash or securities to maintain a required level of equity in the margin account, the broker will sell the securities at the market price, resulting in a sharp financial loss to the investor. The investor is required to repay the broker for any losses. The margin call concept protects the broker that has loaned money on securities.
For example, in Table 14.2, the 100 shares of Greenfield priced at $80 were originally valued at $8000, consisting of investor’s equity of $3200, or 40 percent ($3200 + $8000), and -$4800 borrowed from the brokerage firm. Assume that the stock price drops to $60 per share, resulting in a current market value of $6000 for the investment. Because the investor still owes $4800, his or her equity has dropped to $1200 ($6000 + $4800), which is now only 20 percent of the value of the securities ($1200 $6000), rather than the required 40 percent. The broker, operating with a 25 percent margin requirement, will immediately make a margin call and demand that funds or collateral be added to the account to bring the equity up to a minimum of 25 percent. In this example, to maintain a 25 percent margin, an additional $300 ($6000 X 0.25 - $1500; $1500 $1200 = $300) would be required.
Selling Short Is Selling Stocks Borrowed from Your Broker Buying
a security with the hope that it will go up in value the goal of most investors is called buying long. You might suspect, however, that the price of a security will drop. You can earn profits when the price of a security declines by selling short. In this trading technique, investors sell securities they do not own (borrowing them from a broker) and later buy the same number of shares of the security at a lower price (returning them to the broker). Thus, the investor earns a profit on the transaction. Brokerage firms require an investor to maintain a margin account when selling short because it provides some assurance that the investor can repay the firm for the borrowed stock, if necessary. As a result, some or all of an investor’s funds deposited in a margin account are effectively tied up during a short sale. Many brokers hold the proceeds of a short sale, without paying interest, until the customer covers the position by buying it back for delivery to the broker.
An Example of Short Selling. As an example, suppose you believe that the price of Greenfield stock will drop substantially over the next several months. You have heard that some top managers of the company may resign and that competitors are expected to introduce newer products. Accordingly, you instruct your broker to sell 100 shares of Greenfield at $80 per share ($80 X 100 - $8000). In this illustration, assume that you have a 40 percent margin requirement, which means you have committed $3200 (0.40 X $8000). The shares are actually borrowed by the broker from another investor or another broker. Several months later, Greenfield announces lower profits because of strong competition, and the share price drops to $70. Now you instruct your broker to buy 100 shares at the new price and use the purchased shares to repay the borrowed shares. You gain a profit of $1000 ($8000 - $7000), ignoring commissions, providing a return of 31.3 percent ($1000 $3200).
Using Margin to Sell Short. A very small price drop can provide big profits for the short-term investor who sells short and uses margin-buying techniques. As an example, imagine that you sell 100 shares of a $10 stock with a 40 percent margin requirement. The committed funds amount to $400 (0.40 X $1000). Even if the price of the stock declines by only $1, you still earn a significant profit: 100 shares sold at $10 equals $1000, minus 100 shares bought at $9 equals $900, for a profit of $100 and a return of 25 percent ($100 $400). The price could decline in just a day or two. This possibility of a fast, high return explains the allure of such investments.Almost unlimited losses can occur with the use of margin tosell short if the price rises rather than falls. If the $10 stock soars to $22, for example, the loss will exceed the original investment: 100 shares sold at $10 equals $1000, minus 100 shares bought at $22 equals $2200, for a loss of $1200 and a negative return of 550 percent ($2200 $400). When the price of a security rises, short sellers are subject to margin calls. Only a small proportion of investors sell stocks short because this approach is so risky. Selling short and buying on margin are techniques to be used only by sophisticated investors. Rydex Investments and ProFunds sell short index mutual funds, allowing market timers to profit during bear markets.
Selling Short Is Selling Stocks Borrowed from Your Broker Buying
a security with the hope that it will go up in value the goal of most investors is called buying long. You might suspect, however, that the price of a security will drop. You can earn profits when the price of a security declines by selling short. In this trading technique, investors sell securities they do not own (borrowing them from a broker) and later buy the same number of shares of the security at a lower price (returning them to the broker). Thus, the investor earns a profit on the transaction. Brokerage firms require an investor to maintain a margin account when selling short because it provides some assurance that the investor can repay the firm for the borrowed stock, if necessary. As a result, some or all of an investor’s funds deposited in a margin account are effectively tied up during a short sale. Many brokers hold the proceeds of a short sale, without paying interest, until the customer covers the position by buying it back for delivery to the broker.
An Example of Short Selling. As an example, suppose you believe that the price of Greenfield stock will drop substantially over the next several months. You have heard that some top managers of the company may resign and that competitors are expected to introduce newer products. Accordingly, you instruct your broker to sell 100 shares of Greenfield at $80 per share ($80 X 100 - $8000). In this illustration, assume that you have a 40 percent margin requirement, which means you have committed $3200 (0.40 X $8000). The shares are actually borrowed by the broker from another investor or another broker. Several months later, Greenfield announces lower profits because of strong competition, and the share price drops to $70. Now you instruct your broker to buy 100 shares at the new price and use the purchased shares to repay the borrowed shares. You gain a profit of $1000 ($8000 - $7000), ignoring commissions, providing a return of 31.3 percent ($1000 $3200).
Using Margin to Sell Short. A very small price drop can provide big profits for the short-term investor who sells short and uses margin-buying techniques. As an example, imagine that you sell 100 shares of a $10 stock with a 40 percent margin requirement. The committed funds amount to $400 (0.40 X $1000). Even if the price of the stock declines by only $1, you still earn a significant profit: 100 shares sold at $10 equals $1000, minus 100 shares bought at $9 equals $900, for a profit of $100 and a return of 25 percent ($100 $400). The price could decline in just a day or two. This possibility of a fast, high return explains the allure of such investments.Almost unlimited losses can occur with the use of margin tosell short if the price rises rather than falls. If the $10 stock soars to $22, for example, the loss will exceed the original investment: 100 shares sold at $10 equals $1000, minus 100 shares bought at $22 equals $2200, for a loss of $1200 and a negative return of 550 percent ($2200 $400). When the price of a security rises, short sellers are subject to margin calls. Only a small proportion of investors sell stocks short because this approach is so risky. Selling short and buying on margin are techniques to be used only by sophisticated investors. Rydex Investments and ProFunds sell short index mutual funds, allowing market timers to profit during bear markets.
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