Leverage is widely known in the form of a mortgage to buy a house. It is used in its greatest degree in options trading. More typically, it’s used in a margin account, used to trade securities. Trading in a margin account can lead to a margin call, if the value of the asset falls below a certain amount. This post will explain the ins and outs of these topics, and will add about three more horse questions to the collection…Here is the first one:
Q013) What is the meaning of leverage as it applies to securities trading?
A013) Leverage can be created through options, futures, margin and other financial instruments. These allow the result of an investors speculation to be amplified. Leverage increases the amount of the investment, but not the amount of equity. Moves in the stock price, for or against the investor, will affect the investors bottom line to a greater degree than if the investor had 100% equity in the security.
One of the biggest factors leading to the 1929 Stock Market crash, and the Great Depression was investors overleveraging on bullish speculation. Sound familiar? Cut to the Housing Market crash almost a century later… People were buying property with no money down, and didn’t even need to prove the ability to pay the mortgage. Liar Loans, a.k.a. No-Doc or Limited Documentation Loans along with ‘teaser’ rates, all based on speculation that houses would continue climb in value at double digit rates, unprecedented at any time in history. Let’s talk about a ‘margin account.’
Q014) What is a ‘margin account’
Q014) A margin account is one where the investor borrows some of the cash used to make the investment from the broker, and secures that loan with the securities in her account.
During a bull market that lasted for six years –from Fall 1923 to Fall 1929, that saw the Dow Jones Industrial average quadruple, margin requirements were very lax. An investor could purchase stock for as little as 10% down. The other 90% would be fronted by the broker. To understand leverage; this meant that a 5% move in the stock price would mean a 50% move in the investor’s equity. A 10% move in the leveraged security would mean a 100% move in the investors initial equity.
Let’s do some margin math:
Calculating the amount of equity you have in your account is called: Marking to market.
The law now requires that brokers lend no more than 50% of the value of the equity held in an investor’s account. The equity is not allowed to fall below 25% before a margin call will be issued.
Q015) What is a ‘margin call,’ also referred to as a ‘fed call’ or ‘maintenance call’
A015) A broker’s demand for additional securities or cash to bring the equity in a margin account back up to a level in line with securities law, and the brokers formula.
A broker has every right to sell your stock, whichever they choose, to cover the drop in equity. They do not need you permission. As an added kick in the ass, usually, they will also charge you a commision.
Now let’s talk options, which when it comes to leverage, are like margin accounts on steroids…
Q016) What is an options contract?
A016) Options come in the form of ‘calls’ and ‘puts.’ For the cost of a ‘premium’ they give an investor the option to buy or sell the underlying security at the ‘strike price’ at some time in the future, up until the expiration date of the contract. One contract usually controls 100 shares of the underlying stock.
This means that a $1.00 move in the stock price realizes a $100.00 move in the value of the options contract. In terms of leverage, that’s like 99% ! Hedge funds are typically made up of very complicated combinations of put and call options.
Q017) What are naked options?
A016) A naked option is when the options contract is held by an investor who doesn’t have any holdings in the underlying security, and therefore is not using the options contract to hedge his position in the underlying security.
The SEC is loosening up the regulations regarding advertising and marketing high leverage and therefore high risk investments. However, it says that those ‘high rollers’ will still need to be accredited investors. Here is the ‘headline’ of the SEC proposal, dated August 29th, 2012:
The Commission will consider whether to propose rules to eliminate the prohibition against general solicitation and general advertising in certain securities offerings. The rules, which are mandated by the Jumpstart Our Business Startups Act, (JOBS Act) relate to solicitations and advertising conducted under Rule 506 of Regulation D of the Securities Act and Rule 144A of the Securities Act.
The above blurb was taken from an article posted at ProPublica.org. Check out the full article. It’s current and interesting.
Some say this will lead to disaster for investors, even ‘accredited investors’ in line with the Bernie Madoff fiasco. But where were the restrictions on mortgage companies like Countrywide, in advertising to Harry Homeowner, to leverage his home equity and/or good credit on a financial position that would cost him the roof over his head if the market moved against him? There wasn’t even a requirement that mortgagees take a class before signing on the dotted line, and betting the farm, literally. They had to take the word of their loan officer, a.k.a. ‘mortgage consultant’ who made a big commision, even compared to the commissions and fees a hedge fund manager gets, percentage-wise. Some say that this proves that the U.S. Government didn’t learn its lesson from loosening regulations on mutual funds and mortgage banking.
I think I know what they are up to, and I like it. Remember, this proposal is coming out of the JOBS Act. Just because an individual needs to make $300,000 per year, or have a net worth of $1,000,000 to be considered an ‘accredited investor’ permitted to buy these investments, doesn’t mean you can’t be poor as a shit-house rat to sell them. You only need to pass FINRA’s Series 7 Exam, along with the State Exam. Can you say ‘transfer of wealth?’ I thoughtcha could!
- The 10 Most Common FINRA Securities Arbitration Claims in 2012 (minnesotaattorney.com)
- Clarifications to New Suitability and Know Your Customer Rules Underscore Their Importance (financialcounsel.typepad.com)
- Sharp Rout Prompts Record Japan Margin Account Trades – Bloomberg (bloomberg.com)
- Is it time to load up on Long Calls on CORN? (optionsanimal.com)
- Jim Willie: 60,000 Metric Tons of ALLOCATED Gold Likely Used by Cartel to Settle Asian Margin Calls (silverdoctors.com)