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69 | The Pros and Cons of Margin Trading: A Comprehensive Guide

Updated: Oct 9, 2023


Disclaimer: This article is for educational purposes only and does not constitute financial advice. The author bears no responsibility for any losses incurred as a result of using margin financing. Investors should seek professional advice before investing in margin.


Introduction: History and Fun Facts about Margin Trading


Margin financing has been around for over a century, and it has played a critical role in the development of the modern financial system. The first margin loan was granted in 1929, just a few months before the stock market crash that precipitated the Great Depression. Margin financing was initially developed to allow investors to purchase securities they couldn't afford to buy outright. It enabled small investors to participate in the stock market and helped to democratize investment.


The term "margin" refers to the difference between the value of the securities purchased with borrowed funds and the amount of the loan. The margin represents the investor's equity in the investment and is used as collateral for the loan. If the value of the securities falls below the margin, the investor is required to deposit additional funds to maintain the required equity level.


Why Margin?


Margin financing is an attractive option for investors for several reasons. Firstly, it allows investors to leverage their capital, meaning they can invest a larger amount of money than they would be able to otherwise. This can lead to higher potential returns. Secondly, margin financing can be used to diversify a portfolio by investing in a broader range of securities than would be possible with cash alone. Thirdly, margin financing can be used to hedge against downside risk by shorting securities.


Strategies to Use Margin


When it comes to using margin financing, investors have various strategies at their disposal. One of the most common approaches is to purchase stocks that are predicted to increase in value. By leveraging their buying power with borrowed funds, investors can acquire more shares, potentially amplifying their returns. This tactic is typically known as a "bullish" strategy, as it relies on the market going up.


On the other hand, short selling is a "bearish" strategy, which involves borrowing shares and selling them, expecting the price to fall. When the stock drops, the investor can buy the shares back at a lower price and return them to the lender, pocketing the difference. This strategy is riskier than buying stocks outright, as the potential losses are unlimited if the stock continues to rise.


In addition to these two primary strategies, investors can also use margin to buy income-producing securities such as bonds or dividend-paying stocks. This approach allows investors to generate income from their investments while still benefiting from the leverage provided by margin financing. It's a less risky strategy than buying stocks, but the returns may be lower.


Traps and Disadvantages of Using Margin


While margin financing can be an effective tool for investors, it is not without its risks. One major disadvantage is the potential for significant losses. Because margin financing amplifies gains, it also magnifies losses. If an investor's equity in the investment falls below the required margin, the investor may be required to deposit additional funds to maintain the required equity level or face the forced liquidation of their position. This can result in significant losses, especially if the value of the investment falls rapidly.


Another disadvantage of using margin financing is the cost of borrowing. Interest rates on margin loans can be significantly higher than other forms of borrowing, such as a mortgage or personal loan. This can significantly eat into any potential gains. In addition, using margin financing requires careful monitoring of the investment and the margin requirements. The market can be volatile, and sudden price movements can quickly deplete an investor's equity and trigger a margin call. This can require constant attention and the ability to quickly react to changing market conditions, which can be stressful for some investors. There is also another potential trap using margin: over-leveraging. While margin financing can provide increased buying power, it can also lead to over-investment and over-exposure to a particular stock or sector. This can be especially problematic if the market experiences a downturn or if the stock underperforms.


Famous Incidents about Investing Through Margin Financing


There have been several high-profile incidences where investors have experienced significant losses due to margin financing. One of the most famous incidents involving margin financing occurred during the Great Depression. In 1929, a stockbroker named Joseph P. Kennedy (father of future US President John F. Kennedy) made a fortune short selling stocks using margin financing. He reportedly made $4 million in a single day by shorting the stock market. Kennedy was one of the few investors who saw the crash coming and was able to profit from it. Nevertheless, there have also been unfortunate occurrences related to margin financing. One of the most famous examples is the collapse of the hedge fund Long-Term Capital Management (LTCM) in 1998. LTCM was heavily leveraged, with a debt-to-equity ratio of 25 to 1, and suffered massive losses when the Russian government defaulted on its debt. The resulting margin calls forced the fund to liquidate its holdings, resulting in losses of over $4 billion.


Another example is the case of Jerome Kerviel, a former trader at Societe Generale who lost over $7 billion in unauthorized trades in 2008. Kerviel used a combination of futures contracts and delta-one products to take large positions, and he hid these trades by falsifying documents. When the trades were uncovered, Societe Generale was forced to liquidate Kerviel's positions, resulting in significant losses.


Rules and Regulation about Margin in Malaysia Malaysia has had rules and regulations about margin financing for many years. The Securities Commission (SC) has been regulating margin financing since 1995 and has issued several guidelines and regulations over the years to ensure that margin financing is conducted in a fair and transparent manner. In 2017, the SC issued the latest version of the Guidelines on Margin Financing, which sets out the rules and requirements for brokers and clients who engage in margin financing activities in Malaysia.


The guidelines aim to ensure that brokers are responsible for ensuring their clients are eligible for margin financing and have adequate knowledge to understand the risks associated with it. Regular assessments of the financial position of clients must also be conducted to ensure they can meet their margin obligations. Brokers must implement adequate risk management systems to supervise clients' positions and make sure that they comply with margin requirements. Clients must furnish sufficient collateral to cover their margin loans, and brokers must maintain strict segregation of clients' assets to protect them in the event of the broker's insolvency. Brokers must provide clients with clear and accurate information about the risks and costs related to margin financing. It is crucial to follow these guidelines to ensure the safety of investors and the stability of the financial system in Malaysia. To enjoy this facility one will need to deposit collateral in the form of cash and/or shares traded on Bursa Malaysia. The minimum financing amount for Share Margin Financing is RM50,000. Interest will only be made applicable for outstanding balance. To apply for margin financing in Malaysia, you will need to visit your nearest bank branch or share investment center. You will need to bring your IC and latest pay slip or income statement. If you are an existing Maybank2u user, you can apply for a Share Trading/Margin Financing account online.


Conclusion


Margin financing can be a useful tool for investors looking to amplify their returns, but it is not without risks. Investors must understand the risks involved and have a clear strategy in place before using margin financing. It is also important to choose a reputable broker and adhere to the rules and regulations set forth by the Securities Commission to ensure the safety of your investments. Remember, investing always comes with risks, and it's important to do your research and consult with a financial advisor before making any investment decisions.


TL;DR

1. Margin financing was developed to enable small investors to participate in the stock market.

2. Margin financing allows investors to leverage their capital, diversify a portfolio, and hedge against downside risk.

3. Investors can purchase stocks that are predicted to increase in value or short sell stocks that are expected to drop.

4. Disadvantages of using margin financing include potential significant losses, high borrowing costs, and over-leveraging.

5. Margin financing requires careful monitoring of the investment and the margin requirements.

6. High-profile incidents involving margin financing include the Great Depression and the collapse of Long-Term Capital Management (LTCM) and Jerome Kerviel's case.

7. Malaysia has been regulating margin financing since 1995 through the Securities Commission (SC).

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