Understanding Margin and the Associated Risks
Basics, Requirements, and Maximum Drawdown Analysis
A powerful tool in the financial world, leverage enables investors to amplify results.
Consider a $100 investment that earns a 10% return. An investor able to contribute half and borrow half would achieve an effective 20% return on their initial capital of $50.
The benefits of using leverage are clear – investors are able to leverage other people’s money to build wealth. The upside reward may seem attractive and compelling, especially considering the performance of stocks over the long-term.
This effect, however, also has implications on the downside. Considering the same scenario, a 10% decrease on the initial investment of $100 would have resulted in a 20% loss on the investor’s original investment of $50.
Beyond amplifying losses, leverage can lead to unintended consequences, such as forced liquidation at the worst possible time. In certain cases, leverage can wipe out an investor’s entire portfolio, and possibly result in additional liabilities beyond the portfolio.
Margin Basics
Margin is the use of borrowed funds to purchase positions using those same positions as collateral.
Margin can be used across different asset classes such as commodities, foreign exchange, and securities, amongst others. Different assets have different risk profiles and therefore difference constraints and policies. Commodities and foreign exchange, for example, typically allow for greater leverage than securities.
Focusing on securities, not all brokerage accounts allow the use of margin. A brokerage account can be designated as a cash account or a margin account. Cash accounts do not have margin enabled. When opening a margin account, investors sign and agree to the additional conditions with regards to margin use.
Margin is applicable when the value of the positions exceeds the portfolio value. The investor’s cash position would be negative, representing the debt owed to the brokerage firm.
Note: Some trades, such as shorting shares, may require margin even if the account does not need to borrow cash to open the position. This is beyond the scope of this article.
Following the opening example, the investor’s net portfolio value would be $50 and positions, or stock value, would be worth $100. The difference is the loan amount on margin.
Net portfolio value: $50
Stock value: $100
Borrowed: $50
Like any other loan, the investor must pay interest on the amount that is outstanding and eventually pay the loan back. As of January 30th, 2021, Interactive Brokers charges margin interest rates of 0.75%-2.59%.
Brokers are able to offer margin to investors at attractive rates because the loans are backed by collateral – collateral that the brokerage firm controls.
In that light, brokerage firms have various policies, mechanisms, and procedures to ensure the loans are repaid.
Initial margin requirements. Criteria that must be satisfied in order to open new position. A common requirement is that the account maintain a portfolio value equivalent to at least 25% of the stock value, allowing for 4x leverage.
End of day initial margin requirements. Criteria that must be satisfied at the end of the day in which a new position was opened; also known as Regulation T. Per regulation, this requirement calls for accounts to maintain a portfolio value equivalent to at least 50% of the stock value, allowing for 2x leverage.
Maintenance requirements. Criteria that must be satisfied on an ongoing basis. An account with a 25% maintenance requirement would be required to maintain a portfolio value of at least 25% of the stock value, allowing for 4x leverage.
Margin call. When an account is in or near violation, the brokerage firm may request additional funds in order to ensure the account is in good standing.
Forced liquidation. While the brokerage may give an investor a few days to fund the account with a margin call, the firm reserves the right to liquidate positions at any time to raise funds to repay the loan.
Margin Requirements
Margin requirements are a fundamental risk management tool applied by brokerages. The lower the margin requirement, the higher the leverage available to investors.
A 50% margin requirement implies investors can use 2x leverage, i.e., using $50 to invest in $100 worth of stocks
A 33% margin requirement implies investors can use 3x leverage, i.e., using $33 to invest in $100 worth of stocks
A 25% margin requirement implies investors can use 4x leverage, i.e., using $25 to invest in $100 worth of stocks
The initial requirements limit the maximum leverage for successful investments. The maintenance requirement allows for higher leverage, but only applies in the case of loss. Together, the initial requirements and maintenance requirements define a built-in buffer to resist instantaneous margin calls.
For illustration, suppose the initial margin is 50% and the maintenance requirement is 25%. In order to initiate a $100 investment, the account must have a net portfolio value of $50. The next day, the maintenance margin becomes applicable, dropping the requirement to $25.
If the stock value moves up 50% from $100 to $150, the net portfolio value increases to $100, a gain of 100% for the investor. The leverage is now 1.5x ($100 portfolio value, $150 stock value), as opposed to the initial 2x ($50 portfolio value, $100 stock value).
Conversely, if the stock value moves down, the leverage will increase. If the stock value were to drop 33.33% from $100 to $66.67, the net portfolio value drops from $50 to $16.67. This represents a 66.67% loss to the investor, whose account is now leveraged 4x ($16.67 portfolio value, $66.67 stock value) and on the cusp of a violation. In other words, this account is able to absorb a drop of up to 33.33% in the stock before crossing over into violation.
Brokerages have significant latitude to change their margin policy for any multitude of reasons including increases in volatility, investor risk, or risk from specific issues. These unexpected changes can have unintended side effects on investors, potentially placing their account in violation.
Scenarios & Maximum Drawdown Analysis
The amount of leverage used has implications on the portfolio’s ability to withstand market volatility.
As demonstrated previously, a portfolio using margin for 2x leverage would have a maximum allowable drawdown of 33.33%. The table below shows the implications and account status at various drawdown levels.
By reducing leverage, a portfolio will be able to withstand increased volatility without crossing over into a violation.
A portfolio that uses margin for 1.5x leverage has an allowable drawdown of 55.56%.
A portfolio that uses margin for 1.1x leverage has an allowable drawdown of 87.88%.
Given the initial leverage ratio, the drawdown limit can be calculated for any scenario. The following graph plots the maximum allowable drawdown for the given initial leverage ratio.
The full details are provided below.
Conclusion
Margin is a very powerful tool that can be used to amplify gains, generating significant wealth. This same power, however, can be catastrophic, especially when used incorrectly. Investors can protect themselves by ensuring a wholistic understanding of margin and the associated risks before jumping in.
Disclosure: Margin trading involves interest charges and risks, including the potential to lose more than deposited or the need to deposit additional collateral in a falling market. Before using margin, customers must determine whether this type of trading strategy is right for them given their specific investment objectives, experience, risk tolerance, and financial situation.
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Torre Financial is an independent investment advisory firm focused on opportunities in equities across the value, growth-at-a-reasonable-price, and high-growth segments.
Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
https://torrefinancial.substack.com
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