Using margin accounts for hot stocks? Don't get burned

Filed under: Focus |

Baseball Hall of Famer Yogi Berra is credited with saying: “It’s déjà vu all over again.” This particular saying may have particular relevance to today’s investment scene – with some potentially unfortunate consequences.

Over the past several months, investors enjoyed the appreciation of many stock prices – just as they did in the months before the stock market “bubble” burst in 2000. And some of these investors are buying these risky, volatile “hot” stocks on the margin; that is, they are borrowing money from their brokers to pay for these stocks. Margin account balances grew rapidly this year – similar to the way they did back in 1999 and early 2000.

Why does this recent investment history seem to be repeating itself? Let’s look back to the technology stock boom in the late 1990s. When prices soared, investors learned that they could make money over a relatively short period of time. As we now know, many of these investors got burned. Yet, some of these same people believe they learned from the experience, and they believe they can make money trading “hot” stocks. They are so confident that stock prices will rise that they are willing to buy these stocks on the margin.

Of course, margin trading is risky, because it frequently involves the trading of volatile stocks. For margin transactions to be profitable, stock prices have to rise high enough to cover the commissions charged on the purchase, the commissions charged at the sale and the interest the borrower is charged on the loan. If not sold at its high, the profit is quickly eroded by these charges.

As an investor, can you pick the right “hot” stock? Can you control the impulse to “ride a stock up” in an effort to wring out every possible dollar of profit? Can you tell the difference between a temporary “dip” and the beginning of a significant price drop?

And, perhaps the most important question is: Can you come up with the funds immediately to meet a “margin call”? You might face a margin call if the value of your collateral – the stock in your brokerage account – no longer meets the requirement for the amount of money that you borrowed. Typically, a brokerage firm will lend you 50 percent of the value of stock that your purchase. If the price of the margined securities falls too far, and the equity in your brokerage account slips below a certain level – generally, 30 to 35 percent of the value of the account – then you may get a “margin call” from your brokerage firm.

To meet this margin call, you may have to liquidate some investments – but if the market is declining, it’s a bad time to be selling stocks. So, if you’re going to be a margin trader, you need to have reserve funds available to ride out a drop in stock prices. And you need to know when to cut your losses.

Margin trading has its rewards – but it certainly comes with some hazards. To trade on the margin, you need patience, discipline and the right disposition – and, as we’ve seen, you need to have enough liquidity to face the unpleasant margin calls. In short, margin trading is not a good strategy for those people who think they can make money quickly on “hot” stocks.

Ultimately, you need to ask yourself this: “Are you an investor or just a trader?” There’s a big difference between the two.

Tom Carlson is an investment representative with Edward Jones Investments. He can be reached at 719/635-9992