Buying on Margin, Answering CT

This started as a reply to CT's comment in my last post, but it became very involved, so I made it the post for today.

To CT: While I certainly agree with the assertion that leverage is not inherently evil (and I talk about that often), I do always suggest considering the risk vs. rewards of leverage.

While taking loans for mortgages and education both have future value and are necessities, buying stocks/options are not.

Consider then how you can win using margin.

At the usual 10% APY interest, we're talking daily interest rates of 0.028% a day, or about 3 bps.

For now, lets just consider stocks. Obviously, you want stock that is rising at a relatively good clip. If the stock doesn't appreciate on average at least as much as you accrue in interest, you're losing money. But say it gains 11% in the next year. After paying interest, you have 1% left over from the part you borrowed money for, of which you hope you can pay the transactions fees and maybe make some money.

Now consider what happens if the stock doesn't do so well. Say it gains 10% in the next year. After paying interest, you still owe money for transaction fees associated with selling the stock. You would end up down for the part you borrowed money for.

Next, consider that you can be faced with the issues of margin calls. The Federal Reserve mandates that margin can only be used to finance up to 50% of a purchase, and must then be maintained at at least 25% of the purchase. Say suddenly that the market drops from under you. Not only will your investment began to lose money, but when the amount falls below the required amounts, your brokerage can sell your stock for you, at most likely an even lower price, since it would most likely be a period of panicked selling. When this happens, you will lose not only your initial investment, but you can owe the amount you borrowed and the interest accumulated.

And that's only with you leveraged 2:1. When you apply margin buying to options, you can be leveraged up to 8:1 or more, meaning you have the potential to lose up to 7 times your investment.

This is a type of risk I would classify as excessive. The upside to buying on margin is low, while the downside is greater than your initial investment.

If you compared this to a mortgage, if your property suddenly dropped dramatically in value, rather than forking over the difference to the mortgage company, you can just default on your loans and hand the deed of the property to them, without paying any more than your initial down payment. If you lose on margin, you can lose your investment, plus any other assets you still have.

I would never suggest an investment strategy where you can lose more than you put in. This is one of those that you should not try.