Of the many tools available to help you enhance your investment returns, margin can be indispensable. If used safely, it can greatly speed up your portfolio’s growth by allowing you to buy twice or even thrice the number of shares for the same amount of money, thereby doubling or tripling your profit potential.
But just like any tool, if used carelessly, margin can cause your portfolio serious harm, doubling or tripling your losses if your investment moves the other way. Before using any tool, we need to understand how to use it properly.
In today’s safety lesson on the use of margin, we will look at the tool’s design: how it is used, how it can help us get our work done more quickly, and how it can cause us serious injury. We’ll then look at three simple applications where margin works its magic.
The Tool’s Design
For a complex tool, margin really has a very simple purpose – it allows you to borrow funds from your broker to purchase extra shares, thereby increasing your buying power.
The minimum margin amount you are required to have in cash is generally 30%, 50%, 60%, or 100% of the stock’s price, depending on the stock’s trading volume and volatility.
For example, the heavily traded SPDR Dow Jones Industrial Average ETF (NYSE: DIA), which tracks the performance of the Dow Jones Industrial Average index, has a minimum cash margin requirement of 30%, meaning you can purchase the stock that currently trades at $160 for just $48 if you have a margin account.
The more volatile ProShares Ultra Dow 30 ETF (NYSE: DDM), which is a 2x leveraged ETF that moves twice as much as the DJIA index, has a minimum cash deposit requirement of 60%, meaning that you can purchase the stock for 60% of its price.
Meanwhile, stocks with moderate volume and volatility usually require 50% margin, whereas stocks trading on low volume and high volatility, such as the 2x Leveraged E-TRACS Wells Fargo BDC ETF (NYSE: BDCL), cannot be purchased on margin at all, but require the full 100% cost in cash.
Any portion you do not cover with your own cash is paid by your broker at a generally affordable interest rate, usually ranging between 2 and 5% per year charged in monthly slices. So if you buy one DIA share for the lowest allowable margin of $48, your brokerage firm would be lending you the remaining $112 outstanding.
Margin’s Benefits and Dangers
Did you notice the enormous potential buying on margin affords you? It allows you to double or even triple the number of shares you can buy. Where $160 in a cash account would limit you to just one share of DIA, that same $160 in a margin approved account would allow you to control 3.3 shares of that same stock.
So far this year, the Dow Jones index has risen about 20%. But if you had purchased the DIA on the minimum margin requirement of 30%, you would have a profit 3.3 times greater than the index, or a 66% return on the money you put in.
But while this leverage can help you outperform the market significantly going up, it can also cause you to underperform significantly coming down. In fact, it can completely wipe out your account in a rather short period of time.
Buying a stock on 30% cash means that a drop of 30% in the stock’s price would leave you with zero cash. Yet you would still owe your broker the 70% you borrowed to buy the stock. If you do not immediately deposit additional funds (answering the dreaded “margin call”), your broker would sell your position, take his money back, and leave you with nothing.
Buying on margin, then, is a bet that the stock you are buying will not fall more than the percentage you put in. It is a risk that should be taken only if you have additional emergency funds available to quickly deposit into your account in the event of another 2002 or 2008 correction, in which the major indices fell between 40% and 55% in a matter of just a few months.
Three Useful Applications
Now we get to the fun part – how to put the positive attributes of margin to good use.
Amplifying Capital Gains and Dividend Yield:
The example above – where margin allows us to control a position 3.3 times the amount of our cash – amplifies the capital gain potential of an upward move, while at the same time amplifying the capital loss potential of a downward move.
But that same power of leverage can be used to amplify the yield from any dividend stocks we may have. We can start with a low risk, moderate yield dividend ETF, such as SPDR Barclays Short Term High Yield Bond ETF (NYSE: SJNK), which currently yields some 5.17% on a full cash position.
Though it can be purchased on 30% margin, we’ll settle for 50% margin, since it is a bond fund, and we expect some downside risk in bonds when interest rates begin to rise in the future. 50% margin would allow us to control twice the position, doubling the yield to 10.34% of the money we put in. Not bad at all.
This SJNK version of the fund holds shorter duration corporate bonds of 5 years and less, and it will suffer less volatility than its older sister, the SPDR Barclays High Yield Bond ETF (NYSE: JNK), which holds longer duration corporate bonds. What is more, when interest rates finally rise, SJNK’s yield will rise faster than JNK’s yield, since shorter bonds roll over into higher yielding bonds sooner.
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Combining Gains and Yield:
Margin can also be used to combine the benefits of two stocks into one position. For instance, since we expect equities to continue rising in this low interest rate environment until at least 2016, we decide we want to be invested in a major index ETF, say the DIA noted above. But we also like the idea of that nice dividend yield from SJNK and other high yielding stocks.
Margin allows us to hold them both, combining the best of both worlds by taking a little cash out of our DIA position and using it to purchase SJNK. But not too much, since we are long-overdue for a correction in equities, and an upcoming tapering of the Fed’s bond buying program is expected to trigger a pullback in equities soon.
So we decide to purchase the DIA index on 66% margin, allowing us to withstand a 66% correction – more than enough downside coverage. The 33% we borrow from our DIA position we then put into SJNK, also on 66% margin with 33% borrowed.
Split this way, a $1,000 investment would purchase $1,000 worth of DIA plus $500 of SJNK. Our combined margin would remain the same at 66%, with only 33% borrowed, while our combined dividend yield from both stocks would increase to some 5%. We have all the upside of DIA that we would have had in an all-cash position, plus twice the dividend yield that DIA pays on its own.
What margin allows us to do, then, is take dormant cash out of a stock position and put it to work in a higher yielding instrument to boost our return without sacrificing any upside potential. Just don’t get carried away and take too much out to support another position, for in doing so your account can now lose money in two positions, no longer just one.
The Margin Pyramid:
A third application where margin comes in handy is riding market cycles up and down. If you think of leverage as a pyramid, it should be thinnest at a market’s top and broadest at its bottom.
The longer a market has risen without a correction – as it has for two years already – the greater the likelihood of a pullback. At times like this, you may wish to take precautions and reduce your margin leverage, perhaps not using any margin at all so as not to amplify your losses.
Conversely, after the market has corrected, there is considerably less risk in the system. At times like that you may wish to utilize your margin allowance more fully to increase the number of shares you control. As the market rises, you progressively sell your extra shares and taper your leverage like a pyramid.
Like any tool, margin can increase your productivity as well as increase your danger. Know your tools well, practice with them first, and always use them with care.
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