BusinessDay... the voice of business: Pros and cons of trading  in the stock market with loans

Pros and cons of trading  in the stock market with loans
================================================================================
Okoko Davidson Chidiebere on 26 March, 2008 12:00:00
 
When we signed up for a brokerage account on behalf of our company, AAA Capital
Markets and Real Estate Corporation with the online discount brokerage firm, TD
Ameritrade (which is based in Omaha, Nebraska), one of the privileges and
provisions accorded us  was the opportunity to trade stocks on margin. In view
of this we were invited to open a margin account, and we did. The compay had to
ask us to indicate if we required a margin account, ability to trade options and
others and made us sign several papers. We did, though we had to pledge the
securities and other property in our account as collateral for these loans. We
were compelled to sign an undertaking that trading securities on margin involve
a variety of risks, which included:
*Possibility of losing more funds than I deposit
*Broker's authority to enforce the sale of securities if it falls below the
maintenance margin
*Right of broker to sell securities without contacting the account holder
*Denial of accountholder rights to choose which securities or other assets in
their account that can be liquidated to meet the margin call.
*Non-entitlement to an extension of time on a margin.
What is a margin loan and margin account?
The word "margin" is defined by the Finance and Investment Dictionary as "the
amount of money(or value of assets)deposited by a customer(or client) to a
broker in order to qualify for a loan to trade securities, or for a margin loan.
Similar to collateral, margin may also be deposited by a broker with a clearing
member of a futures exchange". So there may be two types of accounts namely a
cash account and a margin account that is usually held at a brokerage firm. So
you can borrow money, as we have said earlier written, against securities that
you already own-provided these securities are held in a margin account. A client
may be able to borrow up to 50 per cent of the value of common stocks, mutual
funds, and corporate bonds. For more readings on these words, please refer to my
previous articles. If you want to trade US Treasury Certificates, you can borrow
as high as 90 per cent! Think about that! The greatest advantage of margin debt
is the low interest rate. TD Ameritrade charges about 1.95 per cent per annum.
Back home in Nigeria, the following percentage of capital(principal) is
borrowable:
*First Bank of Nigeria PLC-up to 70 per cent of the principal can be borrowed
on margin
*UBA -60 per cent of your capital can be realized through margin borrowing
*BankPHB-80 per cent of the capital can be borrowed
*Standard Chartered Bank(Nigeria)-66 per cent of your capital can raised by
margin borrowing.
Rules governing margin loans:
Certain rules govern margin loans, including the initial margin maintenance
requirements for margin accounts. These include:
*A maintenance of US$2000 minimum equity. Here sufficient funds must be
maintained to meet margin requirements at all times.
*There is a surcharge or margin interest payable by the account holder, on any
credit provided to him/her for the purpose of purchasing, carrying or trading
any security.
*There is a base rate which brokerage firms utilize to compute your levy and
utilize this rate to set margin interest rates.
*Interest: Each day the customer's account is debited, the interest charged for
that day is calculated by multiplying the applicable interest rate by the debit
balance, with the result divided by 360. The sum of the daily interest charge is
totaled at the end of each Account statement period and is posted to the
customer's account on the first Business Day of the following Account Statement
period. Credit balances in the short account will earn interests. There are also
other rules and regulations.
In Nigeria,  and in Broad Street in particular, several brokerage firms lend
facilities to their clients (customers) on margin basis. The minimum equity for
these clients to participate ranges from as high as N500,000 (Five Hundred
Thousand Naira only) to N1million (One Million Naira only). So may clients may
end up not meeting the equity threshold. However, there are now investment
schemes that more or less work like margin account (trading), now offered by
some Nigerian banks, certain brokerage firms, issuing houses, trustees, fund
managers etc. These include UBA Share Plus, First Bank of Nigeria Share Purchase
Facility, Ecobank's Ecoshare, Bank PHB's Share Acquisition Schemes etc. Please
contact your financial institution of investment adviser for more information.
Example of a Share Purchase Facility: UBA Share Plus. In this type of equity
loan programme:
*You are not required to have a current account, though having one will be
advantageous.
*Easy and speedy access to loans. These loans can be used to buy shares of
blue-chip companies as frequently as possible for 12 months.
*The repayment schedule (amortization) is flexible.
*The contract is renewable
*Professional management of your portfolio by UBA Stockbrokers.
Get in touch with a financial adviser for more information. You can make
further enquiries for other banks listed atop.
Margin requirments
Assuming you put up cash in the amount of US$10,000 in each case of 1,2,3,4
above, you could buy on margin:
*US$35,000 worth of marginable stocks or US$33,000 worth of listed corporate
convertible bonds through First Bank of Nigeria PLC
*US$25,000 worth of the products through UBA Share Plus
*US$50,000 worth of stocks or convertible bonds in BankPHB
*US$30,000 worth of shares/convertible bonds in Standard Chartered
Bank(Nigeria)Ltd. Please note that these amounts have been denominated in US$ to
reflect simplicity.  Most of the products offerable are denominated in Naira. If
you want to trade US Treasuries(bills, notes, bonds etc, your US$10,000 equity
contribution will entitle you to buy on margin securities worth US$20,000! Think
about that again! That's the  power of financial leverage. You should try to
utilize it. It is also called Other People Money(or OPM). And leverage id
defined as the ability to do more with less. In this example, you are using a
great chunk of your lender's funds to transact business of high volume, while
contributing a lower amount.
Margin accounts and what happens at wall street
In Wall Street, you can invest on margin in nearly every issue(stock or bonds)
on the New York and American Stock Exchanges respectively and in nearly 2000
Over-The-Counter (OTC) securities. In my previous article, I wrote that OTC
stocks are those that are not listed on any organized stock exchange, but are
rather traded by broker-dealers who communicate using computer networks or
telephone. Note also that you could buy stocks on margin at the NASDAQ market,
one of the biggest OTC market. As I had earlier written, to open an account you
must sign a margin agreement that includes a consent to loan securities. The
margin account agreement states that all securities will be held in "Street
Name", that is by the broker. The consent to loan means that the broker can lend
your securities to others who may want them for the purpose of selling short.
EXAMPLE: Suppose you want to buy 100 shares of ABC Ltd which sells at US$20 a
stock. In a regular cash account, you would put up US$2000(US$20
X100=US$2000).But in a margin account, you only have to put up 50 per cent of
the purchase price(i.e US$1000) or less, as the case may be, plus commission,
which is usually less than 2 per cent. Your broker lends you the other US$1000
and charges you interest on it.
The case of shenandoah telecom:leverage of margin trading
Prior to  30 July 2007,our company made a deposit of US$2000 to TD Ameritrade
Inc. for the purchase of shares of Shenandoah Telecoms. This company, whose
ticker symbol is Shen is listed on the New York Stock Exchange. Immediately
prior to the purchase, we discovered that the company's buying power(BP) had
doubled. In other word, an additional US$2000 was extended to us by TD
Ameritrade Inc totaling of US$4000. As a result, we were not only able to buy
enough stocks, we also bought more than we had budgeted and still have a balance
left. At a market price of US46.50 per share, we bought 74 units of Shenandoah
totaling US$3,450.99, less the brokerage commission of US$9.99 and which was
later waived because we were entitled to it. On 31 July 2007 (a day later), the
price of this stock soared to US$48.07, which represents a US$1.57 gain or 3.37
per cent. If you annualize this rate, it becomes 1,285.74 per cent per annum.
It's just like using US$23.25(50 per cent of US$46.50) to make a profit of
1285.74 per cent  in a year! That was a fabulous return, further buttressing the
importance of margin trading.
Factors to consider before trading on margin
Margin Equivalent Yield(MEY): This is by far the most important element to look
for and compute before you dive into that harmless-looking investment
opportunity, where margin loans are offered. It is actually your yield when you
include the debit interest, the return rate etc. Most brokers never bother to
comment on this to their clients and these clients end up making worthless
decisions and ventures. For example, on a certain day, I was offered a loan
facility to purchase a particular IPO.
The margin contribution (i.e mine) is 20 per cent,while the company will
advance 80 per cent of the capital. The interest chargeable to me was put at 25
per cent and the amortization period was one year.
I accepted the invitation. But when I sat down and did a mathematical analysis
based on the MEY,I saw that I was already at a loss, given that the cash yield
percent was 8.31 per cent.So I later declined the offer. You too, must learn to
do this type of analysis.
2.Look at the Return On Margin(ROM):This is a ration expressed as:
Realized Return   X 100
Initial Margin
Initial margin is the amount of money up to 50 per cent of the purchase price
of securities that can be bought on margin, which is a loan from a broker. In
the USA, the Federal Reserve's Regulation T sets rules governing margin.
Annualized Return is given by:
(ROM + 1)year/trade_duration
For example, if a trader earns 10 per cent on margin in 2 months, that would be
77 per cent annualized return. Two 20 per cent gains compounded in1 year equals
a 44 per cent annualized rate of return. If you use full margin, your compounded
return would be nearly 100 per cent.
Sometimes,ROM will also take into account peripheral charges such as brokerage
fees and interest on sum borrowed.
This calculations will serve as a guide to your profitability. Return On Margin
is used to judge performance because it represents the net gain or net loss
compared to the exchange's perceived risk as reflected in required margin.
3.Rate of Return of Investment(Cash Yield Percent):Please try and determine
precisely what that investment you want to put that loan into will generate in
terms of return before you actually inject your funds therein.
MARGIN TRADING:SHOULD I OR NOT ENGAGE IN IT?
In Dun and Brad Street Guide To Your Investments 1999,Nancy advises that you
desist from margin trading if:
1.You lack the temperament
2.You are dealing in small amounts of money
3.You cannot absorb losses
4.Your portfolio consists primarily of income equities
5.You tend to buy and hold stocks