To a lot of people, just a mention about derivatives and margin accounts will send shiver down their spine. This is because one way or another, most of us who are involved in financial markets have been burned by one of the above investment vehicles. Derivatives such as options and futures are actually pretty safe, if not how can the authorities and regulators approve such investment vehicles.
Derivatives are safe
Options and futures are designed for the purpose of hedging. For example currency options are for Multinational Corporations to manage their foreign exchange exposure in their global operations.
Equity options are for people to hedge their portfolio against any undesirable movements in the equities markets. If you are long on ABC shares and if you believe the underlying market conditions will soften. What you can do to protect your downside? One way is to buy a put option on ABC so any downside movement of ABC stock will be hedged.
Interest rate Options are for large institutional investors to protect their large bond positions and also to speculate on changes in the interest rates. A large institutional investor can protect its bonds position against any drop in the interest rate by buying an interest rate put option. Since the price of bond varies inversely with the interest rate, any drop in the interest rate will result in an increase in the bond price. However, by buying a put option on the interest the investor not only enjoy the upward movement in the bond price but at the same time also protects the drop in the interest rates through its put options.
Misuse of Derivatives
The problem with these investment instruments, are that some people instead of using these tool as hedging used it as for speculative purposes. That is where the problem arises. Some people buy put equity options even though they are without any physical shares to deliver when the market go against them. This is what we called a naked short and it can be serious problem because there is no limit to your losses.
Good and Bad of Margin Accounts
Anyway coming back to margin accounts. It is actually a tool to ‘leverage’ your bets in the stock markets. It is a tool that enables investors using a small amount of money to control a larger piece of an asset. The number of times of leverage an investor will be entirely left to the lenders. It ranges from 100% for an individual investor and up to 2000% for hedge funds and institutional investors.
However, margin accounts works two ways, leverage correctly will increase your profit tremendously but leverage wrongly it will wipe you out.
For an illustration, an investor started off with a $50,000 account and he doubles up his account by using margin to $100,000. If the market is heading downwards, a 10% decline in his portfolio ($10,000) will result in a 20% loss on his original amount ($10,000/$50,000 x100). However, if you are trading in a bear market, it may last many months and eventually it might cause your portfolio to drop by more than 55%. Hence a drop of 55% will translate to a $55,000 loss. This will wipe out his original capital of $50,000 plus an additional of $5000 owing to the broking firm.
Similarly, if his portfolio goes up by 50%, this will mean that his portfolio will now worth $150,000. The profit of $50,000 will translate to a 100% gain on his original capital. So as you can see, margin accounts if used correctly will enhance an investor’s return tremendously.
It can be seen during the last crash in 2008, where some global indexes drop by more than 70% and needless to say those who are on margin got wipe out. Most investors blamed their losses due to margin accounts. However it is also be noted that there are times where margin accounts are the most useful tool to make money. Thousands of individuals and highly successful investors such as institutional and hedge funds make use of the margin accounts to their fullest advantage.
Time to use margin
The problem is when is the right time to use Margin Account for trading?
The answer is during period of gradually rising market or during the infancy of a bull run. When markets are rising gradually, profits will also rising gradually and losses will be the least of your concern. Individual stocks that are quietly rising from their period of hibernation and beginning to rise on increased volume are most suitable for margin trading. With the increase of capital through the utilization of margin account, an investor can truly increase his profits many fold.
However margin accounts cannot be use all the time for trading. During bear markets, margin accounts had to be sent to the ‘freezer’. Another period where margin account should not be used is during the blow-off stage of a bull run. When used during these periods, I can guarantee that you will be sent to the gutters soon.