1 Big Problem With Margin Trading

"Margin can you make you rich..."

Like the sirens' song, margin calls out to investors with an appetite for risk. Its lure has ruined many, yet its skill at printing money in bull markets is often tough to resist. However tempting margin may sound, prudent investors should avoid it at all costs.

Here's the big problem with trading on margin: What will you do when your stocks fall?

The ins and outs of margin trading
Straight from TD AMERITRADE's (NYSE: AMTD  ) Margin Handbook, a margin-enabled account offers investors a way to make money from borrowed money:

[B]ased upon Regulation T of
 the Securities Exchange Act of 1934, which is currently 50%, you can double the amount you invest in qualified securities as long 
as you maintain the minimum value in your account and conduct
 all trades within your margin account. As an example, if you were buying $10,000 worth of marginable securities, you could make the purchase using $5,000 of your money and $5,000 of your brokerage firm's money. Investors who buy on margin pay interest on the loan portion of their purchase (in this example, $5,000), but normally do not have to repay the loan itself until the stock is sold. After repaying the margin loan, any profit or loss belongs to the individual investor.

It doesn't sound too bad, right? At least not until you understand the cost of margin. Your hard-earned equity is now your broker's collateral; and they will protect their collateral -- even if they have to take control of your portfolio to make it happen.

When you trade on margin, you become a slave to the unpredictable whims of the market, paying interest while you're at it.

The Margin Handbook continues:

Since the value of the marginable securities in your account serves as collateral for the loan, margin accounts require that your equity meet or exceed certain minimum levels. If it should drop too low, your brokerage firm will ask you to increase the value of your account by trading assets held in your portfolio, such as selling securities, buying to cover short positions, or closing options positions. Or you may deposit marginable securities or cash into the account.

How would you like your broker to tell you to sell your favorite stock when you're sure its plummeting price is not reflective of its intrinsic value? In fact, you would prefer to buy more shares as prices fell, but instead you were forced to sell shares at a loss to meet your broker's equity requirements. That's no fun. And that's probably exactly what happened to many Apple investors over the past 10 months.

The Apple problem
As Fool contributor Evan Niu recently pointed out, Apple's underperformance combined with the sheer volume of clients trading the stock on margin has weighed on TD AMERITRADE's margin balance.

During TD's most recent earnings conference call, "[CEO Fred] Tomczyk acknowledged that this is very much related to Apple, as the Mac maker is one of the most popular investments among margin investors," Evan explained.

For the most part, the company's metrics echo a resurgence of confidence among its clients as the market touches new highs. But this isn't the case when it comes to the company's margin balance, a very important interest-earning asset for brokers.


Source: Data retrieved from 10-Q filings for respective quarters shown.

TD AMERITRADE's Apple problem highlights what I feel is one of the biggest problems with trading on margin. I can imagine some of these investors who really believed in Apple might have wished to add to their position as Apple stock fell. In fact, maybe they wish they could buy shares today; Apple stock is still down 35% from its September 2012 high of $705. But thanks to a leveraged account, many investors who would have preferred to buy more shares were likely left with no buying power -- or even worse, were forced to sell Apple shares at irrational lows.

Where's Rick Guerin?
Have you ever wondered what happened to Warren Buffett and Charlie Munger's third partner, Rick Guerin? Or maybe he's so long gone that you've never even heard his name? Leverage had its way with him. As value investor Mohnish Pabrai told the Motley Fool in an interview, Buffett told him that "Rick was just as smart as us, but he was in a hurry." Levered with margin loans, Rick's ambition was his downfall.

What does Warren Buffett think about margin? The two lessons Pabrai took away from his lunch with Buffett both seemed to directly defy margin trading:

  1. Avoid leverage.
  2. Be patient.

Too bad Guerin didn't understand these important principles. Forced to sell his class-A Berkshire Hathaway shares at a fire-sale price of less than $40 due to a margin call, he sold the very stocks he probably desired to load up on.

And who was there in the 1973 and '74 downturn to buy Guerin's undervalued Berkshire stock? None other than Warren Buffett himself. Free of leverage, he had cash on hand to load up on the shares he thought were a good deal.

Patience wins in the end
Margin kills. Margin prevents investors from having cash when it's most useful. Don't invest on margin. Instead, be patient. In doing so, you'll empower yourself to buy when everyone else is selling.

I can't think of any better motivation to avoid margin's tempting lure than the advice Buffett shared with Pabrai: "If you're even a slightly above-average investor who spends less than they earn, over a lifetime you cannot help but get rich if you are patient."

Apple has a history of cranking out revolutionary products... and then creatively destroying them with something better. Could Apple pull off this stunt yet again? Read about the future of Apple in the free report "Apple Will Destroy Its Greatest Product." 


Read/Post Comments (15) | Recommend This Article (39)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 07, 2013, at 10:18 PM, cynfool8 wrote:

    Over-leveraging = bad; perhaps the real test is knowing what constitutes over-leveraging. I don't view over-leveraging any differently than abuse of other forms of credit. I use margin more like a short-term loan to initiate or increase a position when I don't have (or want to have) cash immediately available, but never more than a fixed percentage of my portfolio and never more than other assets I could liquidate if I wanted to keep the position after a margin call. Otherwise, it's like making a bet--and we all know sometimes those pay off and sometimes they don't.

  • Report this Comment On August 09, 2013, at 7:22 PM, csqrd wrote:

    I use a slightly different approach for additional leverage. It starts with identifying good solid companies that you would thrilled to own at current stock prices but you don't have the cash or don't want to commit the cash. In my account with margin, I will sell PUT positions to open, when I can get a good discount to current price with the commission, that are deep in the money. (Typically these are a year or more out.) The margin covers the obligation without having to borrow the money. This can provide time to accumulate the cash to buy the shares on the exercise date, or if the price appreciates quickly, you end up with the commission. The risk of course is an early exercise or a market crash so I strongly support cynfool8's comment above on limiting the amount relative to your portfolio value.

    On Tuesday, I sold 7 $22.5 Jan 2015 Puts on SZYM for $14.01 per share commission. Shares were selling for about $11.50 so this gives me a discount to current share price at exercise of 26.2% and puts my break even point at $8.49 per share. This provides a good margin of safety to price gyrations. If as I expect, the share price in Jan 2015 is over $22.50, I will lose out on the shares but be able to keep the $9.807 commission to help buy the shares at market value.

    The real value of margin for me is being able to take advantage of unique situations like this without needed a big cash reserve. Why didn't I sell more to take real advantage of a 49% annualized return using other peoples money? (Read cynfool8's comment 1 more time. It's excellent advice.)

  • Report this Comment On August 09, 2013, at 7:25 PM, darrellquock wrote:

    What happened to Rick Guerin?

    He changed his name to Bill and had a nice hockey career.....

  • Report this Comment On August 09, 2013, at 8:38 PM, mikecart1 wrote:

    Good article.

  • Report this Comment On August 10, 2013, at 12:47 AM, awallejr wrote:

    Nothing wrong with margin providing you know how to use it. Personally I like using margin when I sell to open puts. Costs me nothing if the stock performs better than I wanted. And if performance is lower, well then I bought that stock at a discount.

  • Report this Comment On August 10, 2013, at 1:28 AM, invaluewetrust wrote:

    Margin is great for TRADING, not so much for investing, especially if you don't have a stop out. Leverage is actually the greatest thing on the planet. It gives the little guys a chance and must be respected. Discipline is essential.

  • Report this Comment On August 10, 2013, at 4:49 AM, mf2013 wrote:

    As one blogger explained it, even opening a margineligible account can sometimes allow your own broker to lend your securities to short sellers even if you never trade on margin.. This makes selection of the wrong broker like betting against your self.

    http://beta.fool.com/beatlesforever/2012/06/04/shortlending/...

  • Report this Comment On August 10, 2013, at 10:20 AM, TMFNewCow wrote:

    mf2013,

    Yes, this is called security hypothecation, but the broker can only lend out your shares if you're carrying a balance. If I remember correctly, the broker can lend out up to 130% of the margin balance (if you owe $10k, they can loan out $13k to short sellers).

    If you do not carry a balance and your shares are fully paid for, the broker can *not* loan them out even if it's in a margin account.

    -- Evan

  • Report this Comment On August 10, 2013, at 10:22 AM, TMFNewCow wrote:

    Also, if you owe a balance and then pay it off, the broker no longer has access to those shares and is no longer allowed to hypothecate, and may subsequently close out the short's position at current prices (another risk that short's face).

  • Report this Comment On August 10, 2013, at 2:57 PM, Mega wrote:

    Is there any evidence that Guerin blew up?

    I think unlike Buffett and Munger, he stopped compounding his wealth very quickly when he retired in 1983. He's still a DJCO director with Charlie Munger.

  • Report this Comment On August 11, 2013, at 1:06 PM, PinkFloydRoadie wrote:

    If I had listened to this advice for the 3 times over the last 12 years when I margined stocks during very unusual market downturns, then I would be missing out on the $230,000 extra money in my account when I got out of margin at a later time.

    Like other comments, margin is a fabulous tool when used wisely and not used all the time.

  • Report this Comment On August 11, 2013, at 10:12 PM, daveandrae wrote:

    I believe the correct term is called LEVERAGE, not "margin", which left to their own devises , most people, not all, but most, overuse, then abuse, then rightly so, suffer the consequences.

    Thus, the saying...."Bulls make money, Bears make money, Pigs get slaughtered."

    Amen.

  • Report this Comment On August 12, 2013, at 12:08 PM, HeyPacketMan wrote:

    Margin/leverage is like operating a flame thrower. You don't want to be facing the wrong way when the wind direction suddenly changes.

  • Report this Comment On August 12, 2013, at 4:38 PM, mf2013 wrote:

    Evan,

    The.problem identified in the cited post, is that some brokers have an agreement that.allows them to loan 100 percent of your securities even if you borrow zero cents. You have to read your brokerage agreement very carefully. One bank that holds our mortgage offered m 100 free trades a year, but because they would be able to loan 100 percent of my stocks I have yet to use the free trades. I will set up a cash account l later. This is a big deal to me. If I am wrong, I would be happy.

    Andy

    P. S. I believe some brokers have agreements like you say, but at least one big bank does not..

  • Report this Comment On August 12, 2013, at 5:17 PM, TheRealRacc wrote:

    Go figure....the most uninformed investors in the market (AAPL fans who invest emotionally) are gambling with millions of dollars on, what else, AAPL.

    Long many other real tech companies.

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