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On Thu, 22 May 97 01:15:32 -0600, mcarso1 wrote:
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Question regarding buying stock on margin (the numbers are just off the top of my head and I don't know or really care if they are correct for this exercise)



Part I



Let's say I purchase 100 Shares of Zeigletics (they make portable toilets) at $100 a share. 50% of it is on margin and the other 50% is my cash for $10,000 in stock. During the year, the Chad Republic has a terrible and high-profile plumbing accident; ZEIGH.H losses its largest buyer. The stock plummets to $45 a share. The phone rings and it is my broker. What options do I have? Can I -



1 - fork out $4500 and keep the stock?

how about

2 - give the broker $500 and tell her to sell the stock for the rest of the money?



Part II



Let's say Zeigletics is totally stagnant and 1 year later is still at $100 a share. Meanwhile, my broker has been charging me 10% a year interest. Does this mean my margin call is now at $6000 and not $5000 (factoring in the interest)?



Part III



What _IS_ a competitive rate for interest on margin accounts?



Mark>>

Mark,

Wow, Zeigletics has done rather well for itself in the last few years! Even at $45 a share! :) For any other readers who are interested in Zeigletics, you can read all about it at :

http://www.fool.com/School/Zeigletics/zintro.htm

Now, Mark, I must tell you up front that my experience with margin has been brief and disastrous. Probably because I didn't do the research to really understand how it works until your question came along. I only thought I understood it. I am going to explain what I found out below, but WARNING: Confirm it with your broker. And don't, repeat, DON'T, use margin until you really understand it. You are playing with fire. And I mean that. You can get severely burned. I've got the scars to prove it. :)

Part 1:

To make it as simple as possible, let's assume you started that margin account with $5,000 cash. Since you are starting out with $5000 cash (it can be securities, but that gets more complicated), you can buy $10,000 worth of stock. At that point, you will have an account which has a $10,000 market value and a $5,000 debit. (The loan.)

Now, this looks like you have borrowed 100% of your starting account balance. Bingo. You have. The margin requirement of 50% means that the equity (stock and cash minus loans) in your account must be kept at or above 50% of the total value of the account. Or, if you prefer you can think of it like this: The amount of money you have borrowed cannot be more than half of the total market value of the account.

It can get confusing if you start thinking of the loan as the STOCK that you bought with the borrowed money--it isn't. The loan is a cash debit against the value of the account. Another common area of confusion is thinking that "50% margin" means you can borrow 50% of the value of your account. It's only LOOKS that way after you have borrowed the money. The main thing to keep in mind is that the loan (debit) cannot be higher than 50% of the total market value of the account Of course, with stocks, the total market value of your account is constantly changing and that's where you can get into trouble.

Now, to use your example, if the value of your equities drops to $4,500, your account will show a current market value of $4,500, with a debit of $5,000. (The stock would have had to drop literally overnight for you to get in this position because otherwise you would have received a margin call loooooong before the stock hit $45.)

The possibilities you mention in your question sound as though you want to close out the account or at least get it back totally in the black. That isn't necessarily the way it works, but let's look at your choices first as though that was your plan and then see what else could happen.

Option #1, fork out $4,500 and keep the stock, won't get you out of the hole. You owe the brokerage $5,000 (never forget that part--it doesn't change except to go up when the interest is added!). To close out the account and keep all of the stock, you would have to fork over the entire $5,000--after all you bought $10,000 worth of stock and only paid $5,000. The fact that it is only worth $4,500 now doesn't change that.

Option #2, ponying up another $500 and selling the $4,500 worth of stock for cash (all of which goes to the brokerage) will clear out the account. In this situation you will have lost $5,500. Which is exactly what happened to the value of the stock. The problem is that you are out $5,500 with nothing to show for it. If you had put up the entire amount to buy the stock in the first place, you would still be out $5,500, but you would also still own 100 shares of stock which could conceivably go back up.

Of course in reality neither of these will completely clear the account because we are ignoring commissions and interest on the $5000 that you borrowed. But that's OK for now.

Now, what are your other possibilities? Suppose you want to keep the stock AND keep the account open. Let's look at some numbers:

Original situation:

Market Value of Account: $10,000 ($10,000 in stock purchased with $5,000 cash and $5,000 margin loan)
Debit (margin loan) -5,000
Equity in account 5,000

Margin Requirement on 10,000 account (50%) is $5,000.
Current equity equals margin requirement. You're cool. :)

But now the account balance drops to $4,500 overnight.

Market Value of account: $4,500
Debit: - 5,000
Equity in account - 500

Margin requirement of 50% on $4,500 equals 2,250. Current equity = -$500
Not cool. Margin call! But now it starts to get weird. You might think you could just deposit (IMMEDIATELY, of course) $2,750, right? Wrong. If you did that, you would have:

Market Value of Account: $7,250 ($4,500 in stock plus $2,750 in cash)
Debit: -5,000 (the $5,000 you originally borrowed--can't forget that)
Equity in account 2,250

BUT the margin requirement on $7,250 is $3,625 in equity--your current equity is still UNDER the required 50% value of the account.

The simple way to look at it is to forget about the margin part and just think--Account balance has to be at least twice as much as the loan balance. (Why they didn't write the regulations that way, I'll never know. It almost seems like they wanted to mislead people--nah, they would never do that. :)

You would actually have to deposit $5,500 to get the account back in balance and you would have to do it RIGHT NOW or the broker will simply sell your stock to repay the loan and send you a bill for $500. Boom--no stock and you owe the broker money. If the stock goes back up tomorrow. . . you lose.

Now, this is an unrealistic scenario--but not impossible. Stocks don't often loose half their value over nightm, thank goodness. But it does illustrate very nicely the dangers of being on margin. The Fool's recommend not using margin at all unless you are very familiar with how it works AND, if you do, keep the margin at 30% or less (keep the amount of money borrowed to less than 30% of the account total.) That gives you some protection if your stocks head south for a while.

You see, even if you are just a little bit below the margin requirement, the broker can still sell your shares right out from under you. Say, you were fully margined as in your first example and Zeigletics only dropped to $95.

Account balance: $9,500
Debit balance: - 5,000
Current Equity 4,500

Your margin requirement on a $9,500 account is $4,750, but your current equity is only $4,500. How quickly the broker might act on this situation depends to a certain extent on the broker, but most won't give you more than a day or two of grace. Out of town or a business trip? Too bad. When you get back you find that 3 shares have been sold to bring your account back into balance--plus you have been charged a commission for the sale. In a situation where the stock drops a bit each day, the commissions on the forced sales can get pretty grim.

In the interest of fairness I should add that using margin can magnify your returns. In the example above, if Zeigletics had gone UP, say, $10, you would have earned a 20% return on your investment of $5,000 by leveraging it with margin borrowing. (Value of your account goes from $10,000 to $11,000--that's a 20% return on $5,000 but only 10% on $10,000.)

Part ll (finally)

Better repeat the question:

<< Let's say Zeigletics is totally stagnant and 1 year later is still at $100 a share. Meanwhile, my broker has been charging me 10% a year interest. Does this mean my margin call is now at $6000 and not $5000 (factoring in the interest)?>>

First of all, 10% interest is only charged on the amount you borrowed so the total interest would only be $500. Or are you thinking that the interest value gets doubled somehow when figuring the margin? Well in either case, your account would never have been allowed to get to this point. As we have discussed, your margin is based on the current market value of your account--not the value of the loan.

If the equity doesn't change and you have used up all of your margin as in this example, the minute the first month's interest was posted to your account you would have received a margin call.

Market Value of account: $10,000 (50% =$5,000)
Loan plus interest: -5,050
Equity value of account: 4,950

Current equity is less than 50% of the Market Value of the account. Or to look at it the simple way, the loan value is more than half of the market value of the account. Get out the checkbook. :)

Part III

<<What _IS_ a competitive rate for interest on margin accounts?>>

Well, I don't think either of us knows enough to be shopping for a competitive rate on a margin account. :) But 1/2 to 1% over broker's call rate (I don't know what that is--that's just what they call it--probably it's the rate the broker is paying for the money) is considered good. You will have to ask around to get actual rates.
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