Using Margin to Enhance Your Returns

Risk Assessment
July 16, 2023

To many investors, margin is a dirty word. It's to be avoided at all costs. Our perspective is that using margin can augment investment returns, provided you're comfortable accepting a higher degree of risk. However, we're not inclined to move up the risk ladder. This approach becomes particularly viable when asset valuations are significantly lower than their historical averages.

It's important to understand how margin can work for and against you so we'll start with some basics.

Some investors fear margin because they've heard of investors being stopped out of their positions only to see the stock recover at a later point. We have friends that have suffered this fate and have lost millions because of it. But there are prudent ways to employ margin that don't significantly increase your risk of a margin call.

Let's start with the basics of margin. If you have a margin account at your broker, you may be able to borrow up to 50% of the value of your equities. There are some exclusions involving the minimum stock price and other liquidity restrictions, but we will discuss those details further in another article..

Below are a couple charts that show how margin can be employed. In the first case, the investor buys 100 shares of a stock at $100/share. They use $5,000 cash and borrow $5,000 from their broker. If the stock drops in price, their losses are magnified by twofold compared to an all-cash purchase. Each line shows the loss per share, their equity, the position value, their equity as a % of the position and their gain loss. If you didn’t add additional funds to your account, your position would be liquidated by your broker when the stock dropped to around $67. The table below illustrates your equity if the stop order hadn't been executed. This scenario would typically occur if there was a considerable drop in the stock's price while the market was closed.

Currently, the minimum maintenance margin required by the Federal Reserve is 25%. Some brokerages have higher minimums. For example, at the time of this writing, TD Ameritrade had a 30% minimum margin.

So, let's walk through a couple of the rows in the above chart. If the stock price drops to $85, you lose $15/share or $1,500 on the 100 shares you purchased. Your equity drops from $5,000 to $3,500 ($5,000 - $1,500). Since the value of your 100 shares is now $8,500, your equity percentage drops from 50% to 41.18%. Since this is above both the Fed's (25%) and TD's (30%) minimum margin requirements, no action is taken.

If we move to the next line, that's where the margin call comes into play. If the stock drops to $65, your loss per share is $35 or $3,500 on the 100 shares you purchased. Your equity is now $1,500 ($5,000 - $3,500) and your equity percentage is 23.08%. This is below the minimum. You'll receive a margin call from your broker asking you to deposit more money. If you don't, they'll sell your stock and you'll have booked a loss.

In this case, the stock dropped 35% and you were stopped out. On a volatile stock, a 35% drop is not a 2-standard deviation event,It happens frequently. When investors look at this scenario, many decide margin isn't for them.

Let's look at the second chart, which represents the same stock and same stock price decreases. The only difference is the initial margin percentage. In this case, the investor uses $8,000 cash and a $2,000 margin loan. It's important to remember that 50% is the maximum amount you can borrow when you put on the trade but it's not the optimal amount.

As you can see in the above, the stock can drop 70%, from $100/share to $30/share and you wouldn't receive a margin call even with TD's tighter restrictions. This is a very important concept to grasp. Leverage isn't a bad thing. There are different degrees of leverage and it can be used to your benefit as long as you understand when, where and how you are using it.

Let's talk about the "when" first. If you're using market valuation measurements, it's much more prudent to use moderate leverage when the market is significantly undervalued as opposed to using it for a momentum play when the market is riding high.

Next, the "where". If you're using moderate leverage (20% as shown above) to buy the S&P 500 index or another broad index, like the MSCI World index, it's unlikely although not impossible that your investment is going to lose 70%+ of its value and trigger a margin call. The same could not be said for one drug biotech stock that's waiting on FDA results from a Phase 3 trial.

Lastly, let's mention the "how". How you use leverage is a very important point. As illustrated in the 2 tables above, a moderate amount of leverage has the ability to enhance your returns with minimal risk of having to liquidate your position at an inopportune time.

Some of our models have the option to use very moderate leverage to gain additional exposure to, what we feel are, temporary, significant, market undervaluation. Let's say one of your investing models indicates you should be 100% long stocks when the S&P 500 index is 30% or more undervalued. What do you do if the market continues to drop and becomes 50% undervalued? If you don't have the leverage option, you can’t be more than 100% long so you would be missing a very rare, potential opportunity to capitalize on a short-term market mispricing.

When you're using margin, it's very important to call around to check rates. Interactive Brokers (IB) often offers margins rates that are several percent below that of other brokers.