Margin No-no's
All this margin talk is scaring me.
Don't EVER use margin to buy the same stock you're using as your margin equity. Sure, its great when the stock climbs, but if it falls, you'll implode. A simple illustration follows:
Fred owns 10,000 shares of WAVX at $10/share (equity=$100,000)
Fred's broker has a 50% margin requirement which equals $50,000
Fred buys 5,000 addtl ($50,000) shares on margin (now maxed out)
Scenario 1
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WAVX drops to $8 a share
Fred's equity drops to $80,000 and now may borrow only $40,000
Fred has borrowed $50,000, so he gets a margin call for $10,000
Fred must deposit $10,000 or sell 1,250 shares of WAVX
If Fred cashed out now, his holdings would be worth $70,000.
If Fred never bought on margin, his holdings would be worth $80,000.
Not bad you say? Only a difference of 12.5%, right?
Scenario 2
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WAVX drops to $6 a share
Fred's equity drops to $60,000 and now may borrow only $30,000
Fred has borrowed $50,000, so he gets a margin call for $20,000
Fred must deposit $20,000 or sell 3,333 shares of WAVX
Fred doesn't have the cash, so he sells 3,333 shares
WAVX rises to $10 a share 3 days later
Fred using margin: his holdings would be worth $86,700.
Fred not using margin: his holdings would be worth $100,000.
Moral:
Fred lost $14,000 and WAVX is at the same price when Fred bought it. Greed cost Fred bad, 14% of his original investment for a net-zero move in stock price.
Scenario 3
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WAVX drops to $4 a share
(student exercise)
Take it from someone who has been there, don't be a Fred. Just remember when the bubble breaks, it doesn't take long before it makes a wet spot.
---Slate |
