This is second episode in "Gambling Insights".
We looked into "Leverage" in last episode. In this episode, we will dig deeper into how we can use that leverage in equity (stock) investments.
Leverage used in stock market is called as "margin".
What is margin? How does it work? What are all the risks involved in it?
How can we use that as a tool in our investment strategies? We will review those in this episode.
Hi. My name is Vijay Mohan. You are watching - not investment insights. But Gambling insights.
All brokerages offer Margin account.
Let's say that we have 10,000 worth of stocks in our margin account. The brokerage will match that amount and will offer that as loan.
That is, we can borrow another 10,000 from them and invest.
Why do they trust us with their money? They are not actually trusting us. But they are giving the money trusting on the assets we hold in that account.
They charge an interest for that loan. The interest rate is different across different brokerages.
Here in US, Interactive Brokers are the ones that charges the cheapest interest on their margin loan.
Their interest rate Today is 1.6%. That is, if I borrow 10,000 from them, then I have to pay 160 as yearly interest.
who will give a loan cheaper than this?
What? In-laws? Are you planning on eating at home for dinner or not?
Let's see how this margin account works using an example.
Let's say that I have an Index fund worth of 10,000 in my brokerage account.
That year market has gone up 10%. So our profit is 1,000.
This is in normal cash investment account.
If this is in a margin account, my brokerage will offer a loan of up to 10,000 that matches my asset's worth 10,000 for an interest of 1.6%.
Of that 10,000, if I borrow just 1,000, then my leverage % is 10%.
Because I am borrowing an amount that is only 10% of my assets.
But if I borrow all 10,000 that is offered to me, then that would be a 100% leverage.
Let's say that I am taking full advantage of this 100% leverage.
I am borrowing 10,000 at 100% leverage and investing in an index fund.
Now my total invested amount is 20,000. In that, my money is 10,000 and the loan is 10,000.
If the market goes up by 10% in that year, then my return in that year after paying the interest for the margin loan is 18.4%.
That is 1,840.
"Wow... we have beaten the index using the index itself. Well done... Long live margin account. Why would you call this as gambling? This is the real investment insights." - you might wonder.
Now let's take a look at its dark side. If the index goes down by 10%, then our return will be at -21.6%
Account balance would have gone down to 17,840. Out of that, our balance would be, 7,840.
If the index goes down by 20%, then our return will be -41.6%. Account Balance 15,840. Our balance 5,840.
If the index goes down by 30%, then return -41.6%. Account Balance 13,840. Our balance 3,840.
What do we learn from here? When we are in 100% leverage, if the market goes up, our profit doubles up.
And if the market goes down, our losses will double as well.
OK. What happens if the market keeps going down? Well, our account will go down to zero.
Actually our brokerage will not let our account to go to zero.
Because, they have their money 10,000 there as well. How would they let that go to zero?
Even though we have borrowed the money from them, they will always keep their principal safe.
How do they do that? Let's take a look at this situation where the market has gone down by 30%.
Our account balance at that time will be 13,840. Out of this, 10,000 is their money and 3,840 is our money.
If the total balance goes below 10,000, the brokerage will start seeing loss.
By that time our balance would have gone down to zero. But why would they care about that.
For them, they don't want to lose even a single penny of their money.
For that, they have an inbuilt safety buffer. That safety buffer is "Maintenance Margin".
Let's see how that is calculated.
The percentage of our balance in the total balance is called as "Margin %".
For our situation, 3,840 is 27.75% in 13,840.
This is margin %. That is, the percentage of our balance in total balance is "Margin Percentage".
The minimum requirement on this margin percentage is called as "Maintenance Margin".
In US, by law, this maintenance margin should be at least 25%.
Some brokerages might require this maintenance margin to be up to 40%. But in Interactive Brokers, this is 25%.
OK. For our situation, the margin percentage is at 27.75%.
If the market goes down below 35%, then that margin % will definitely go below 25%.
What happens if that goes below 25%? That depends on the brokerages.
Most of the brokerages will give us a "margin call".
Margin Call means, a warning from our brokerage saying, "Buddy, your balance in your account is not enough for the debt you have. Within 2 days, deposit additional money and increase the margin % above 25%.
"Or, sell your assets in the account and increase the margin %. If you do't take any action for 2 days, we will be selling your assets to bring the margin % above 25%".
When most of the brokerages give margin call like this, Interactive brokers on the other hand does not give any margin call at all.
They will randomly sell a stock or a fund in our account and take the money. From a person who gives loan for cheap, we have to expect that aggressiveness from them.
In our example, our margin % is at 22%.
If it is not Interactive brokers, then they will definitely give a margin call for this situation.
We have two options to bring this margin % to be above 25%.
First is, we can transfer the extra money from our bank account into the brokerage to increase our balance from 2,840.
If we deposit 500, that will bring up our balance to 3,340 and so our margin % will go up to 25%. That is one option.
The other option is to sell the assets in our account to bring down the total balance.
Now our total balance is at 12,840. If we sell 1,500 and pay off our debt, then our balance debt will be at 8,500 and the total balance will be at 11,340.
Now that will bring up our margin % to 25%.
We are not losing anything additional just because we have sold and met the margin call.
Our return was already at -71.6%. It is still at -71.6%.
But the actual loss to us is, if the market recovers and comes up, we would have missed the growth from that 1500. That is our actual loss.
Now we know how a margin account works.
We will see how we can strategically use this in our investments in next episode. Thank You.