Volatility and Leverage: A vicious circle?

Where leverage is involved, a small loss is magnified into a big one.

That bigger loss creates considerable indigestion for the losers.

They see what's happening and rush to deleverage; that is, to sell assets to reduce exposure to volatility.

That rush to the exits creates more volatility.

The cycle continues.

This deleveraging cycle goes a long way to explain the 2008 financial crisis:  the volatility that created it and that it created.

When we look at the causes and consequences of volatility, we can see how it frequently can become a self-fulfilling prophecy, particularly where leverage is involved.

The Advantages and Disadvantages of Margin Trading

The Advantages of Margin Trading

1.   A magnified return is the major advantage of margin trading.

The size of the magnified return depends on both the price behaviour of the security and the amount of margin used.

2.   Another more modest benefit of margin trading is that it allows for greater diversification of security holdings because investors can spread their limited capital over a larger number of investments.



The Disadvantages of Margin Trading

1.   The major disadvantages of margin trading, of course, is the potential for magnified losses if the price of the security falls.

2.   Another disadvantage is the cost of the margin loans themselves.  

A margin loan is the official vehicle through which the borrowed funds are made available in a margin transaction.

All margin loans are made at a stated interest rate, which depends on prevailing market rates and the amount of money being borrowed.

This rate is usually 1% to 3% above the prime rate - the interest rate charged to creditworthy business borrowers.

For large accounts, it may be at the prime rate.

The loan cost, which investors pay, will increase daily, reducing the level of profits (or increasing losses) accordingly.




Take home message:

Margin trading can only magnify returns, not produce them.

One of the biggest risks is that the security may not perform as expected.

If the security's return is negative, margin trading magnifies the loss.

Because the security being margined is always the ultimate source of return, choosing the right securities is critical to this trading strategy.

Margin and Buying on Margin

What is buying on margin?

Borrowing from your broker to buy a security (stock, bond or futures contract) is referred to as buying on margin.

You use the security or other securities in your portfolio as collateral.

When you borrow to buy on margin, you pay margin interest rates set by the broker.  This is usually a fairly high rate, though not as high as a credit card.


Why do investors buy on margin?  

Margin buyers are trying to buy larger positions than they can afford out of pocket in order to get more exposure - leverage - from their investments.

To buy on margin, you must set up a margin account with your broker.

This involves depositing a certain amount and signing several forms indicating you understand the terms and conditions.

This can be done online with online brokers.

Not all securities are marginable.  Some low-price or risky stocks do not qualify for margin buying.


Buying on Margin

When you buy a security on margin, you must have enough collateral to make the purchase.

A margin requirement of 50% for stocks is required in the US, set by the Federal Reserve.

That means you must have at least 50% of the entire purchase available in your account as cash or equity.  This is to prohibit you from borrowing too much.

This 50% requirement only applies to the initial purchase.  After that, rules set by your broker apply.


Margin Call

There is a minimum maintainance requirement below which your equity portion will trigger a sale or a request for more equity (cash) to be whole.  This is a margin call.

A typical minimum maintainance requirement is 35%, meaning that once your equity falls below 35% of the entire stock position, you get the call.

For example, if you buy 1000 shares of a $1 stock for $1000, you can borrow $500 of the $1000.  If the stock drops below the point where the equity portion of the investment is 35%, you will trigger the call.


What is that price when you get a margin call?

The formula is:    Borrowed Amount / (1 - Maintainance Requirement).

If the maintainance requirement is 0.35 and you borrowed $500, the formula would give you the total securities value to match 35%, in this case $500/(0.65), or $769.23.

That means that if your $1 stock goes down to 76.9 sen, you will get a margin call.

Margin positions are evaluated each night for sufficient equity.

The calculation of margin sufficiency is more complex with multiple securities in an account.

The above example applies to stocks; the initial and maintainance margin requirements are differnt for commodities.


What you should know about buying on margin?

Margin can add power to your investment portfolio.

Like any other borrowings, it can be DANGEROUS, and should be treated accordingly.

Margin interest rates, while moderately high, can be lower than some other forms of short-term borrowing, so it might make sense to use margin to get some cash from your investment account for certain purposes.

On a larger scale, when stock margin borrowing levels increase in aggregate, it is a sign that too many people are speculating on stocks and that a bubble might be forming, leading to a bust later on.





Reference:

101 Economics by Peter Sanders

Margin Calls Explained

How The "Leverage-Game" Works

Leverage  and Margin

Margin is defined as the amount of money that is needed as “deposit" to open a position with your forex broker. It is used by your forex broker to maintain your open position. What your forex broker basically does is that takes the margin deposit and lump them with everyone else's margin deposits. It then uses this accumulated “margin deposit" to make transactions within the interbank network.

Margin is often expressed as a percentage value of the full amount of the position. For instance, most forex brokers say they require 2%, 1%, .5% or .25% margin. Based on the margin required by your broker, you can calculate the maximum leverage you can wield with your trading account. Here are the other popular leverage ranges that most forex brokers offer:

Margin Required	Maximum Leverage
5.00%	20:1
3.00%	33:1
2.00%	50:1
1.00%	100:1
0.50%	200:1
0.25%	400:1
0.20%	500 : 1
0.10%	1000 : 1

In addition to "margin required", you will probably see other "margin" terms in your trading platform. These margin terms refer to different aspects of the trading account and they are defined as follow:

Margin required: It is expressed in percentages and is referring to the amount of money your forex broker requires from you to open a position.

Account margin: This is the total amount of money you have in your trading account.

Used margin: This refers to the amount of money that your forex broker has set aside to keep your current positions open. Although the money is still considered yours, you will not be able to use it until your forex broker returns it back to you either when you close your current positions or when you receive a margin call.

Usable margin: This is the money in your account that is available to open new positions.

Margin call: If your open losing positions decreases beyond the usable margin levels set for your account, a margin call will take place and some or all open positions will be closed by the broker at the market price.

The margin is actually used by the forex broker as collateral to cover any losses that you may incur during trading. In actual fact, nothing is being bought or sold for physical delivery to you. The real purpose for having the funds in your account is for sufficient margin.

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