Stocks: Buying on Margin

Lately, I have been investing in the stock market and have been doing pretty well. I guess a lot of what the experts said about the stock market snapping back was true cause I have definitely been able to experience a lot of gains since the recent market recovery. Even though I feel like I have been taking steps in the right direction, there is always room for improvement. During a conversation with one of my colleagues, I was asked about "margins", which is something that I have heard of but do not fully understand. Of course, this would be a perfect opportunity to educate myself about this procedure as well as write an article about it.

"Buying on Margin" has a very negative connotation due to the fact that this is a practice that contributed to the Great Depression that occurred during the 1920s. From my understanding, many people took at loans to purchase stocks however, when those stocks did not appreciate, many people were left with loans that they were unable to repay. The following information is quoted directly from Wikipedia:

During the Crash of 1929 preceding the Great Depression, margin requirements were only 10%. Brokerage firms, in other words, would lend $9 for every $1 an investor had deposited. When the market fell, brokers called in these loans, which could not be paid back. Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their deposits en masse, triggering multiplebank runs. Government guarantees and Federal Reserve banking regulations to prevent such panics were ineffective or not used. Bank failures led to the loss of billions of dollars in assets. Outstanding debts became heavier, because prices and incomes fell by 20–50% but the debts remained at the same dollar amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billion in deposits had been frozen in failed banks or those left unlicensed after the March Bank Holiday.

As with most things, when there is an unclear understanding of how something works, it is very easy for something that is supposed to be used for positive to turn negative. However, after doing some research, the whole idea of buying on margin is not nearly as complicated.

The terms "buying on margin" basically means to borrow money from a broker to buy stock. The money that is being borrowed is not a conventional loan that you can obtain from a bank. It has a lot more regulations and guidelines that have been implemented to try to help prevent a repeat of the "Great Depression". Below are some of the highlights for a margin account:

1. Typically requires a minimum investment of $2000.
2. Usually requires a set margin maintenance fee (used to insure there is enough "cushion" in the event of loss in stock value)
3. Allows you to borrow up to 50% of the purchase price of a stock.
4. This account typically carries an interest rate imposed by the broker on borrowed funds.
5. Penny stocks, OTCBB (Over-the-counter bulletin board) and IPO (Initial Public Offering) stocks do not qualify for margin purchases.

With all of these requirements, it is hard to see the benefits of having a margin account. However, the example below can illustrate why this account has the potential to return great rewards:

Let's assume that you have $5000 in your cash account. You want to purchase a stock that is worth $10 and you believe that it will double in the matter of a year. Instead of limiting yourself to $5000, because you have a margin account, you can purchase $10000 worth of the stock (borrowing up to 50% [maximum] of the purchase price of the stock). In a year, the stock ends up doubling from $10 to $20 and you decide to sell the stock. So the value of the amount of stock you own goes from $10000 to $20000, however, you have to pay back $5000 + interest which is the based on the original amount that you owned. For our example, let's assume that there is 0% interest, resulting in a net profit of $10000.

If you had just used a regular cash account, your profit would have only been $5000.

Margin Account:

Initial Cash Investment: $5000

Amount Borrowed: $5000

Initial Investment Amount: $10000

Final Investment Amount: $20000

Net Profit (Final Investment - Amount borrowed - Initial Cash Investment) = $10000

Cash Account:

Initial Cash Investment: $5000

Amount Borrowed: $0

Initial Investment Amount: $5000

Final Investment Amount: $10000

Net Profit (Final Investment - Amount borrowed - Initial Cash Investment) = $5000

As you can see from the above example, it seems like a really good idea to proceed with investing using margins due to the fact that the return on investment is double of what it is by using cash alone. However, it would be irresponsible to just provide the possible benefit of the accounts without discussing the cons of this type of account.

In the case that your thoughts were incorrect about the particular stock in the previous example and instead of the stock doubling in value, it was halved, things change drastically. Let's review the previous example using these new numbers:

Margin Account:

Initial Cash Investment: $5000

Amount Borrowed: $5000

Initial Investment Amount: $10000

Final Investment Amount: $5000

Net Change (Final Investment - Amount borrowed - Initial Cash Investment) = $-5000

Cash Account:

Initial Cash Investment: $5000

Amount Borrowed: $0

Initial Investment Amount: $5000

Final Investment Amount: $2500

Net Change (Final Investment - Amount borrowed - Initial Cash Investment) = -$2500

As you can see, in addition to the potential for growing your profits exponetitally, you also expose yourself to the potential to grow your losses in the same manner. One more important thing about margin accounts is that the broker reserves to the right to issue a margin call in the event that the value of the stocks has decreased below the threshold of the margin maintenance fee. Since the stocks that are purchased are held as collateral by the broker, they can force the investor to prematurely sell these stocks in the event that the investor's account goes below a certain amount.

An example of this is the following:

Initial Cash Investment: $5000

Amount Borrowed: $5000

Initial Investment Amount: $10000

Margin Maintenance Fee: 25%

Final Investment Amount: $7500

Actual Margin Funds: $2500

Marginal Funds Required in the account: $1875

With the stock price being reduced to $7500, the investor is required to have at least 25% of margin equity in the account. So, the investor is required to have 25% * 7500 of margin money in the account, that amount is $1875. The broker would not issue a maintenance call on this money due to the fact that there is $2500 of margin money in the account exceeding the required amount of $1875.

If the margin maintenance fee was increased to 40%, the marginal files required for the account would be increased substantially. See below for the new requirements:

Initial Cash Investment: $5000

Amount Borrowed: $5000

Initial Investment Amount: $10000

Margin Maintenance Fee: 40%

Final Investment Amount: $7500

Actual Margin Funds: $2500

Marginal Funds Required in the account: $3000

As you can see, the broke would initiate a margin call this margin account to make sure that there is coverage for the amount of money borrowed. This will either result in the investor depositing more money into the account to cover for the call or if the investor does not have the money to the deposit, will result in the broker selling the stocks (investor's permission may not be required).

This defeats the "buy and hold" strategy to attempt to wait out negative swings in stock as the investor may be forced to sell their stock prematurely.

Although this is an advanced topic, it is good to have a bit of an idea of some of the tools that are available to enable you to obtain financial freedom quicker. Please let me know your comments about buying on margin and some of the experiences you have had with "buying on margin".

Stay Disciplined!

Flexible Spending Accounts vs Health Spending Accounts (Part One)

“It is health that is real wealth and not pieces of gold and silver.” ~Mahatma Gandhi

One of the big points that was discussed in the previous presidential campaign that was mentioned was the idea of health insurance. One of Obama's platform is to make health care "affordable and accessible to all". (Citiation) Well, I for one, am a proponent of taking care of yourself without relying on the use of any one (or any entity) for that matter.

I believe that one should use all the tools available to be responsible for ones health care and fortunately there was one tool that was made available by the previous administration if you qualify. The "Medicare Prescription Drug, Improvement and Modernization Act" signed by President George W. Bush in December 2003 created the "Health Savings Account". Below is the definition for this account:

A health savings account (HSA), is a tax-advantaged medical savings account available to taxpayers in the United States who are enrolled in a High Deductible Health Plan (HDHP). (Link to Definition)

A Health Savings Account (HSA) is a special account owned by an individual used to pay for current and future medical expenses. (Citation)

This particular account is somewhat similar to a tax-sheltered account (such as a 401(k) or IRA) that allows you to contribute pre-tax income to spend on health related expenses. Like the 401(k), there are contribution limits imposed annually. In addition to that, these funds can reside in an investment vehicle such as mutual funds and stocks. Although this sounds like a very good product to take advantage of, there are certain requirements that have to be met before you qualify.

In order to be able to contribute to an HSA, the person must be the policy holder of an HSA-eligible high deductible health plan (HDHP). An HDHP is basically a policy that does not cover first dollar expenses (unlike Medicare , Flexible Spending Accounts , etc.) which basically provide benefits as soon as the medical expense is incurred. HDHPs usually have a high deductible (i.e. $1100+ for self coverage, $2200+ family) but a lower premium since they require the policy holder to pay a higher deductible than most other health insurance plans.

For the year of 2008, the maximum contribution to the HSA was $2900 for a person who is single. For 2009, the maximum contribution was increased to $3000 for a person who is single. The money contributed to this account can be withdrawn for any medical related expense. The method of withdrawal is highly dependent on the agreement that the account holder has with the HSA provider. Some HSA providers give their account holders checks or debit cards to use with medical related expenses. Although purchases can be made by these methods, it is good practice to keep documentation of each medical related expense in case the IRS wants to make you prove that the expense qualified for a withdrawal.

Some of the benefits to use a HSA are the following:

• Premiums for HDHP are generally lower.
• HSA provides flexibility to pay some expenses not covered by traditional health insurance such as over the counter drugs, orthodontics and vision.
• Money from the HSAs can be rolled over year after year and available for withdrawal without penalty after age 65.
• Some employers match an employees contribution to the HSA.
  

There are some associated disadvantages with the HSA listed below:

• Non medical related HSA withdrawals are subject to a 10% penalty as well as a standard income tax.
• Qualified medical expenses can only be incurred on the date of or after coverage has started, it is not retroactive.

As you can see, there are advantages to having an HSA. Hopefully you feel a bit more empowered to know your options to take control of your health care coverage if you qualify for this particular product. The next article that will follow up this particular topic will be about "flexible spending accounts" which are easier to qualify for than HSAs.

If you have anymore information about the topic of Health Spending Accounts or want to discuss this issue, please leave that information in the comments below.

Stay Discplined!

Sources
http://www.ustreas.gov/offices/public-affairs/hsa/pdf/all-about-HSAs_072208.pdf
http://en.wikipedia.org/wiki/Health_savings_account