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Macro Economics
Dangers of Margin Trading

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By GuyLeap
March 6, 2009

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Hi All,

I was thinking long today about why I have any money invested in stocks at all. In 1997 and in 2000, I had a good percentage of my net worth in stocks and both times I took a nice beating and learned some lessons around short term trading and who is makes money on trading (mostly the brokerage firms and market makers, not the investors.) So I stepped out of the stock market almost completely.

As some of you may know one of my passions (hobbies) is real estate investing. So I often need funds to buy properties and fix them up. It is not great to have cash sitting around unallocated so I often rely on Lines of credit (LOC) to smooth over the large cash events. But I have been very concerned over the last 2 years that my LOC's in place could DRY up with just a letter in my mailbox.

"Dear Sir- we are sorry to inform you that your home, business etc... has dropped in value or we want to reduce our bank exposure to business loans etc... so we have reduced your LOC from $250,000 to $1. Have a nice day. "

This would greatly hamper my real estate investing hobby and leave me with not much to do on the weekends. So I was looking at re-establishing an equity position somewhat for the automatic built in line of credit that is established that is somewhat not tied to the banking sector; i.e. if you have $100k of stocks you can borrow some portion (typically 50%) of it as needed for other investments.

Well, fast forward to Oct 2008, and I heard the siren call to get back into stocks when the Volatility index (VIX) soared over 70. When I was trading in the past I was writing covered calls so I loved a high VIX. I stepped back in a bit (~10% of assets) to get a LOC and get some investment diversity thrown in. I bought stocks and sold options against them. Well as you can all guess I took a beating again. My new LOC sucks. Not only is the interest rate high but it leaks.

This got me thinking- why do people ever borrow money against equities? I think some people borrow money on equities so that you can buy more equities. But this is pretty risky planning. I looked at what time horizon you need to have to benefit from investing in equities on margin. I did some quick numbers. Others are probably better able to dig into the fine numbers, but here I have looked at round numbers.

-If you bought stocks in 1929 with DOW at 330 it takes you 25 years to recover (1954).

-If you own dividend stocks with a 50% margin it takes you another 1 year of gains (26 years) to cover the margin interest.

Now here is the crazy part.
-If you owned stocks that did not pay dividends it takes until 1994 to break even!!!! (65 years!) I don't have that kind of time horizon.

At that point your initial margin loan of $165 will have ballooned up to $3,900. The Dow is at $4,000 so you are at ~break even with a ~$100 value. You have made money for the margin lender only for the entire 65 years.

Owning non dividend paying stocks on margin seems to be best used for folks that are taking the money out to invest elsewhere, not using it as a means to buy more equities (especially non dividend paying ones.)

Stay as safe as you can investing out there.
Abraham Farag