Recently I wrote an article about investing with margin and honestly, when I was done with all of my research and writing, I actually convinced myself to open a margin account. While some of the math and numbers behind it certainly can be enticing, the potential for a margin call watch to be placed on you is something that is a terrifying thought.
I’m not going to get super in-depth about margin in this post because I did that a couple weeks ago, but as a high-level summary, investing with margin is when you borrow money to be able to invest more.
Typically a lender will let you borrow up to the account value that you have with them, so if you have $10K, then they will oftentimes let you borrow another $10K meaning that the total amount that you can invest is $20K.
Sounds pretty nice, right? What’s the catch?
Well, there’s a couple…
First off, the interest rate is usually very high. I’ve seen some lenders offer interest around 4-5% but Fidelity is over 7% if you have less than $250K in your account, which many of us probably do. And even if you do have $250K with Fidelity, I doubt that it’s all in the same account that you’d be using margin for, but I may be wrong!
So, you’re paying a very high interest rate to borrow money from this lender to be able to invest – that’s the first issue.
The second issue is that the lender can put a margin call watch on your account at any time. What does this mean exactly? Let’s get into it.
A margin call is when the value of the account falls below the minimum amount that the brokerage is willing to extend to you. Imagine in this example that I stated above where you have $20K, $10K of which is in cash that you have and $10K is in margin that you’re borrowing.
If all of a sudden, your investments take a major drop in value then you’re going to be in a really, really tough spot. You see, to the brokerage firm, they don’t care about you. All that they know is that your portfolio is now worth less than it used to be, meaning that it’s less likely that you’re actually going to be able to pay them back.
So, what do they do? They will put a margin call out on your account.
This means that you either are going to be forced to put more money into your account to cover some of those losses or you’re going to be forced to sell some of your stocks to generate capital back for that brokerage firm.
But remember how I said that this only happens when your investments really crash? That means that by design, you’re being forced to sell low. That is the opposite of what you want to be doing! If anything, you want to be buying more!
Maybe you have some funds set aside for an opportunity to add to your account if the stock market does crash and if so, that’s awesome. Like seriously, major props to you for having this opportunity fund. But if you don’t, then you’re going to be locking in major losses and oh yeah, you’ve been paying interest on this margin loan that has lost you money…womp womp.
“But Andy, I only invest in ETFs so I should be totally fine, right?”
Well…no. First off, something that you need to consider is that we very well might be in an ETF bubble. But even if we aren’t, you still are susceptible to some major risk.
For instance, let’s look at what happened to SPY less than a year ago in March of 2020. For those that don’t know, SPY is an ETF that is meant to mimic the S&P 500, so you’re really just about as diversified as you can be amongst those 500 companies and is generally seen as a very safe investment.
As you can see below in the chart from Yahoo Finance, the price for this ETF on 2/19/20 was $338.34:
Literally one month later, that same ETF had its price dropped by 29%, all the way down to $240.51:
That is a massive drop for the total stock market to incur. And guess what – a margin call just got put on your account!
So, what does that mean to you? Well, as I mentioned before, you need to contribute some more funds to your account or you’re going to have to sell some stocks.
Each brokerage is going to have their own requirement for what the necessary threshold that you need to have in your account is, but the common range is anywhere from 30-40%, so I am going to assume a 35% rate.
Basically, if you invested 100% in SPY on 2/19 and lost 29%, then you’d think your breakdown would look like this, right?
It only makes sense that you’d lose 29% from both accounts, but…WRONG!
You see, the brokerage isn’t going to lose money. Instead, you’re going to have to cover all of that on your own, so the breakdown would actually be like this:
The total account value is still the same but you’re the only one that’s lost money, so your losses are effectively doubled.
Now, the nice thing about margin, is that this means that the gains are also doubled as well, but the risk to the downside is just so great for when a margin call watch is put out for your account that it can be permanently crippling. Let’s keep going through the scenario!
So, the main question now is, “are you below that 35% minimum threshold?”
The calculation is pretty simple to do as it’s the amount of your equity / total value in the account. See below:
Uh oh…you’re short by 5.34%! Might not seem like a huge deal but trust me – it really is.
So, since this brokerage, which we will refer to as the Grim Reaper Brokerage, or GRB, is going to come knocking and asking for you to put up that remaining 5.34%, which equates to $758.94:
So, you either need to add that much cash or you need to sell stocks to get you back to that 30% threshold, but that doesn’t mean you’re just going to sell $758.94 in stock. No…it’s much, much worse…
You see, if you’re selling stock, you’re not actually increasing your equity at all – all that you’re going to be doing is reducing your margin balance. So, if your equity is $4,217.06 and you have to have 35% in margin, that means that your account needs to be $12,048.74 in total ($4,217.06 / .35 = $12,048.74):
So, since your previous margin equity was $10,000 and now it’s $7,832.94, that means you’re selling $2,167.06 of stock, a significant amount higher than the $758.94 of cash that you would need to put in.
This might not seem like a huge deal at first but it really is. And my favorite part about this example is that you don’t even have to trust me at all – all that you need to do is see the number for yourself.
Let’s keep going with this same example – here is a summarized timeline of where we are:
- You bought $20K of SPY ($10K your equity & $10K margin) on 2/19
- By 3/19, SPY had dropped by 28.91%, therefore causing your account to get hit with a margin call watch
- You decided to sell stock to cover that margin call, which cost almost exactly 9 shares (240.51*9.01 = $2,167)
On board so far?
“Who cares, Andy? I still have 50 shares – that’s a lot!”
I totally agree with you, but the gains that you’re about to miss…oh boy, the gainsssss…
Below is how your account would’ve looked for the next few months:
Honestly, not the end of the world. Considering that you were forced to sell a lot of your equity, you’re still getting somewhat close to recouping that value back. You’re down about 14% which is definitely not ideal, but considering where you were, it could be worse.
But, if somehow you had been able to contribute that extra $758.94 to your account and keep the brokerage whole, then you’d be in a much better situation. In fact, you’d actually be up!
Pretty crazy to think through all of that that you’re actually up money, right?
“Andy, who cares – I’m up $216…whoopty doo.”
While that is true, how did you fare against your alternative?! That’s right, you actually made $3,082.24 over the alternative of having to sell some of your investments.
As you can see, when a margin call watch is put on your account, you really need to make sure that you have a plan in place or it can be detrimental to your total market returns.
The last thing that you want to do is be in a situation where you’re forced to liquidate some of your positions to cover the margin call. So, if it was me and I was using margin, there are a few things that I would do:
1 – Use Margin Opportunistically and Rationally
What I mean by this is use margin when I think there’s a unique buying situation, such as during the COVID crash. Sure, that might seem extremely risky to borrow money in the middle of a crash, but as long as you have the ability to hold onto some of those holdings, you’re going to reap the rewards.
The main issue with that is that if you buy into a 40% dip when it’s only down 5%, then you’re going to get hit with your very own margin call, right?
So, that takes me to my second tip and probable the most important tip…
2 – Have a Backup Plan
This is so important for you to be able to fund your account if you get a margin call watch issued for your account. You need to make sure that you have already been planning for a way to navigate around these muddy waters to keep you from having to sell your stocks.
Instead, have some cash set aside as an “opportunity fund”. This is something that we have in our high-yield savings account currently just to give us some flexibility in life. This opportunity fund can be used for many things but we make sure to always have at least a couple thousand dollars in it for that “just in case” situation.
This is somewhat like an emergency fund but truly just for opportunities. Some situations might be:
- Covering a margin call
- Increasing contributions to max out a tax-advantaged account (like I did with my Roth during COVID)
- Refinancing a mortgage and using this money for the closing costs
- Doing something fun and unexpected! If a favorite team of yours makes an unexpected run, like Purdue did to the Elite 8 in 2018 (wife is a graduate and avid fan) then you can fund the tickets to go to that event!
The key is this – you’re planning. If you have a plan and stick to it, I am sure that you’re going to be able to navigate things when they get tricky.
The type of people that find themselves in a really rough spot are those that get a message from their brokerage telling them to add $1000 or sell $3000 in stocks and they are just totally lost. If you can do a little bit of legwork on the front-end then you’re going to set yourself up for success, but as I mentioned, it’s all about planning.
And personally, my planning process starts with Doctor Budget. Not only is it super easy to use for the day-to-day tracking, but it gives me the flexibility to easily change the format so that I can plan for future months and make things more personable to my life and my expenses.
If your budget platform isn’t doing this, it might be time to consider making a switch. And even worse is that if you’re not using a budget at all, then you need to fix that ASAP.
After all, I firmly believe that tracking your expenses is the best way to bring awareness to your spending and get you on your way to financial freedom!