If you’re not familiar with how margin accounts work, you can read this other post first. We’ve already seen how a margin account is similar to getting a mortgage or a home equity loan (HELOC.) Today we’ll discuss margin loans and how to avoid a margin call.
A conventional mortgage requires a 20% down payment which means the bank is willing to give out 80% loans. Why 80% and not 60% or 100%? Because a 60% loan doesn’t make them as much money and 100% is simply too risky. It’s not practical for people to buy homes with 0% down. What if the home’s value drops and the buyer walks away? Margin accounts work in a similar way. Lending is based on the risk that banks are willing to take. So how much money can we borrow in a margin account? The actual answer is it depends on what stocks we buy. Some stocks are relatively safe, but others are extremely risky. So banks have organized stocks into a few different lending groups. The safest, defensive group will have a 70% lending value. More risky companies will get a 50% or lower lending value, and for the really risky companies, 0%, (ie: we can’t use any margin money to buy them.) Stocks are always moving so sometimes a company’s lending value will change from one group another, but the bank will notify their clients if this happens. Each bank should have a list of stocks and their respective lending values.
If it’s risky for the banks to lend us money to speculate on stocks, then why do they even offer this service in the first place ಠ_ರೃ ? The reason is the same for why banks give people mortgages. For us, a margin account is a way we can use leverage to increase our profits in the stock market. But for banks, a margin account is a debt instrument they use to earn recurring interest. If we buy stocks using more money than what we deposited in our margin accounts we have to pay monthly interest to the bank on however much money we’ve borrowed. So banks want to make money, but they have to be careful not to take on too much risk. Just like a mortgage, banks don’t care if the price of our stocks (or homes) appreciate or not. They only make money on the interest from lending us money.
The amount of available margin money we can borrow fluctuates everyday because its based on the market value of the shares we hold. If we have $100,000 worth of stocks today with a 70% lending value then our available margin is $70,000. But if the market value of our stocks dropped to $90,000, then the bank can’t lend us $70,000 anymore because $70,000 of a $90,000 asset is 78%. That’s higher than 70%, which means too much risk. So at $90,000 our margin amount changes to $63,000. So we should never max out our margin usage in case our portfolio losses value. As soon as the lending amount crosses over 70% we would get a call like the following “hello, this is your broker, could you please put more money into your account or sell some stocks to bring the lending amount back down to 70% or below.” If we ignore this margin call and don’t take any action, then the broker will sell our stocks for us because if we leave the country and our stock goes to zero, then they are on the hook for that $70,000. Selling our stocks is how banks and brokerages protect themselves.
The way I like to use margin accounts is to buy stocks on margin but not borrow so much that I’ll risk getting a margin call. So if the maximum I can borrow is 70% of my holdings then I’ll only borrow up to 40% or 50% so I have some extra margin wiggle room. Later this week, I’ll walk through a recent transaction in my margin account (゜∀゜)
conventional mortgage – a mortgage that isn’t more than 80% of the purchase price of a home.
lending value – this is the “up to” amount. 70% means a maximum lending ratio of 70% but we can borrow less if we want to. Note: US and Canadian lending values are different due to separate regulatory bodies. A list of 70% lending value Canadian companies can be downloaded here (PDF.)
margin call – When the broker demands the investor deposit more cash into their account to cover possible losses. Investors can also sell their existing shares which will increase the cash amount in their accounts. Either way, the point is to decrease the lending value back to a safe amount.