Wednesday, Sept. 23 was an ugly day for the markets during an already ugly month. The S&P 500 shed 2.37%, the Nasdaq was down 3.02%, and the Russell 2000 fell 3.04%. There wasn't any specific single piece of news that brought the market down. It appears that a combination of a post-August hangover, anxiety about the upcoming election, end-of-quarter rebalancing, and a lack of a new stimulus bill are all playing roles in the current market downturn.
In addition, a smaller story regarding online broker Interactive Brokers (NASDAQ:IBKR) may have contributed to yesterday's decline, and could portend scarier things leading up to the election.
Raising margin requirements
On Wednesday, Interactive Brokers sent a message to clients stating it would gradually raise its margin requirements leading up to the November election.
A margin loan is a loan used by investors to invest in stocks or other securities. However, in order to protect their loans, brokers only allow investors to borrow a certain amount against their equity -- and that equity can fluctuate with the markets.
Interactive Brokers sent a message out to its clients Wednesday that it would be gradually raising its margin requirements through October:
... elevated option implied volatilities indicate that the markets will be confronting elevated volatility both before and after the November 2020 election. IBKR shares that sentiment and believes it's appropriate to start controlling leverage in a measured fashion in advance. Consequently, to protect IBKR and its customers, IBKR will increase margin requirements by as much as 35% above normal margin requirements leading up to the November U.S. election. To illustrate, consider a Reg. T margin account with stock XYZ having an Initial Margin requirement of 50% and a Maintenance Margin requirement of 25%. With the increase fully implemented, the new requirements would be 67.5% Initial and 33.75% Maintenance.
Basically, Interactive Brokers is requiring clients hold up to 35% more equity or cash versus their margin loans between now and the election.
While Interactive Brokers is "gradually" phasing in the higher requirements, the prospect of raising clients' margin requirements could cause Interactive Brokers clients with margin loans to sell stocks they might normally have held, or hold off on buying stocks they might otherwise have bought. Since near-term market movements occur based on supply and demand, that could cause more downward pressure.
In an even worse scenario, severe drawdowns might spook clients into selling at lows. We actually saw this scenario play out in March, when leveraged funds were forced to sell as the market experienced the fastest 30% decline in history.
Interactive Brokers likely remembers this all too well. In fact, the discount broker had to take a $104 million charge last quarter as West Texas Intermediate oil contracts fell to an unprecedented negative $37.63 price in April after the pandemic-related rout. That costly mistake likely played a part in the broker's decision as well.
Could Interactive Brokers cause the very thing it's trying to prevent?
One might wonder if Interactive Brokers' move may in fact cause the very scenario it's worried about, as selling to pay down margin begets more selling momentum. However, it's highly unlikely Interactive Brokers' move in and of itself could cause the entire market to go down meaningfully. Although it's one of the largest discount brokers out there, the brokerage market is huge and fragmented. Yet should other online brokerages make similar moves heading into the election, there could potentially be an effect over the next two months.
So while Interactive Brokers' move in and of itself might not cause the very market crash it's fearing, keep an eye on other large brokerages making similar pre-emptive policy shifts.
What you should do in case of a market crash
The markets are always unpredictable, and this year has been especially volatile. That's why it's best not to trade with borrowed money at all. While using a margin loan can help juice returns on the way up, the opposite can happen in a bear market on the way down. When you consider that margin loan providers can force you to sell as the market goes down in order to keep up margin requirements, the downsides of margin loans largely outweigh the upsides, especially if you're new to investing.
If you're worried about a market crash heading into the election, stick with your plan: Only invest after building an emergency fund, and then only invest in your favored age-appropriate stocks, ETFs, or index funds in regular intervals, with an eye toward holding for the long term. Oh, and don't use leverage bolster your returns.
In sticking with these simple principles, you should be able to sleep well at night heading into the end of the year -- at least regarding your portfolio -- no matter what this manic-depressive market might throw at you.