We woke up this morning to a handful of emails from last night from some of the readers of this blog. Most of the questions were the standard type of questions revolving around if this trade or that trade is a good idea. But we received one that we have not received in many months where the reader asked the question why was stock bought on margin considered a risky investment?
This is a great question for us to write a brief article on because we feel all of our readers can benefit from this one. We will spend the rest of this article giving our response to why was stock bought on margin considered a risky investment?
Most everyone here should know what margin trading/investing is. Borrowing money from your brokerage so that you can apply that money to your account and create leverage. This leverage allows you to invest and trade a notional value that is larger than the net liquidation value of your account. Pretty straight forward. Within a margin account, there are three levels:
- Tier 1 – this type of account only allows for two types of options trades; covered calls and cash-secured puts. For stock, all purchased must be cash secured as well. For a Tier 1 margin account, in order to buy 100 shares of $IWM (Russell 2000 Index ETF) we would have to be cash secured and pay the full $13,865 to hold the stock. In effect, a Tier 1 account is not a margin account.
- Tier 2 – this type of account allows us to go a few steps further as we can have a margin account in Tier 2. We can do everything we were able to do with Tier 1, but now we can also purchase options and create options spreads. If we went out to buy 100 shares of $IWM here, we would only be responsible for putting up 50% of the capital or $6,932.50.
- Tier 3 – this type of account does not have any limits for what we can do. We can do any type of uncovered option trade while maintaining the 50% margin requirements for stock purchases and sales. For uncovered options, we are required to put up 20% of the cost of the stock at the strike price. In $IWM, if we sold a $130 put, in Tier 1 or Tier 2 account we would have to put up $13,000 but in this Tier 3 account, we would only have to put up $2,600.
Why Was Stock Bought on Margin Considered a Risky Investment?
I think we all know the drill with margin accounts. For stock, we have to put up 50% of the capital required (unless you have a portfolio margin account) and for options, you have to put up 20% once you have the permissions for them. But now to answer our question.
I firmly believe that Wall Street has convinced us to worry about risk so that we hand over our money to them. Risk management this…this $VIX is the fear index that…flash crash high frequency trading whatever. It’s all garbage.
At StonyBrookSecurities, we do not focus on risk because we keep our trade and investment sizes small. We spend all day every day worry about opportunity. We hunt opportunity all day long.
So to answer the question of “why was stock bought on margin considered a risky investment?” my answer is:
It wasn’t. Individuals can make investments or trades that are too large in cash secured accounts just as easily as they can in margin accounts. It’s never the actual margin that makes any investment or trade risky, it is always the trade size. You can have a margin account and make an investment that requires $50 in buying power to have $100 in stock just as easily as you can have one that requires $50,000 in buying power to have $100,000 in stock. Again, it is NOT the margin that makes an investment risky…it is purely the size of the investment.