 |
A Message from Kimberly Clouse, Financial Expert:
I have worked in the financial services industry for
nearly a decade in many capacities, most recently as
a financial advisor for individuals. Over the course
of my career, I have had the privilege of working with
a diverse range of people, from the single mother just
starting her own business to the dot.com billionaire.
Based upon my experiences, I have learned that the same
basic principles and lessons apply to a successful and
healthy financial life, whether you're starting out
or cashing out. These guiding principles include simplicity,
a long-term perspective, and above all, knowing that
you have control of your financial destiny, and all
the information you need is well within your reach.
Buying on Margin
Margin accounts, margin calls, and shorting stocks. What
are these and how are they related? A margin account is a
brokerage account in which a customer can buy securities with
money borrowed from the broker. An investor must have a minimum
amount of cash or securities deposited with the broker--the
amount is referred to as the "margin"--when buying stocks
on margin or shorting stocks. An investor typically establishes
a margin account when she wants to either (1) buy stocks on
margin or (2) short stocks.
Buying Stocks on Margin
When an investor buys stocks on margin, she is expecting the
price of the security to rise. Suppose the investor wants
to buy 1000 shares of Acme Corporation stock at the current
market price of $5 per share. To purchase these shares, she
would need $5000 plus any commissions charged by the brokerage.
However, if she were to buy on margin, she would borrow up
to 50% of the purchase price ($2,500) and pay the remaining
$2,500 out of pocket. If Acme stock performs well, she earns
all of the gains on the $5,000 investment even though half
of the purchase price was borrowed. As long as the gains on
the portion bought on margin--$2,500 in this example--exceed
all borrowing costs, then the investor has benefited by buying
on margin. There is typically no set time by which the investor
must repay the margin loan, but eventually, of course, the
investor must reimburse the broker for the funds borrowed
and pay interest (based on the broker call rate).
What if the value of Acme declines? If the stock price falls
below a certain level, then the investor might get a margin
call from the brokerage asking her to contribute more cash
or securities to her account--essentially to serve as loan
collateral. When the margin account is established, the broker
informs the investor of the required minimum ratio of marginable
securities to securities owned outright. If the stock price
falls and the ratio is not maintained, then the brokerage
firm will issue a margin call to the investor, instructing
her to cover the amount of the decline.
Shorting Stocks
When an investor shorts a stock, she is hoping that the price
will decline. When shorting a stock, an investor borrows shares,
sells them immediately, waits for the price to fall, and then
buys them back at the lower price to return to the broker.
The attraction of shorting stocks is that an investor can
make a profit without initial cash investment. The risk is
that the stock price could rise instead of fall, and the investor
could theoretically be exposed to unlimited loss potential
since stocks have no maximum price. Because shorting stocks
involves unlimited risk, the Securities and Exchange Commission
requires brokers to issue margin calls when an investor's
losses reach a predetermined amount.
Margin Requirements
The minimum margin requirement is 50% of the purchase or short
sale price for initial transactions, with a minimum of $2,000.
The percentage that the investor is required to deposit is
set by the Federal Reserve Board and can change from time
to time. The amount required is frequently referred to as
the "RegT" percentage, and RegT applies to each new margin
purchase the customer makes.
The Federal Reserve, National Association of Securities Dealers
(NASD), stock exchanges such as the New York Stock Exchange,
and individual brokerages impose minimum maintenance (as opposed
to initial) requirements. For most securities, the maintenance
requirement is 25% of the securities' total market value in
equity. Certain volatile stocks, or special maintenance stocks,
carry a 50% maintenance requirement.
Marginable Securities
A brokerage firm may only extend credit on securities that
are deemed "marginable" by the U.S. Federal Reserve Board.
Marginable securities generally include securities traded
on the major U.S. exchanges that sell for at least $5 per
share, many over-the-counter (OTC) stocks, government and
municipal bonds, and certain other securities. Margin is applicable
to U.S. securities only. Because of the inherent risks in
margining securities, investors are not permitted to trade
on margin in retirement accounts.
|
|
