Imagine borrowing a cow and selling the milk! What a great idea, isn’t it? It’s like you are borrowing someone’s assets and reaping the benefits. Sometimes in life, you see a no-brainer opportunity right in front of you but you do not have the resources to pursue it.
Likewise, in stock markets, say you have a strategy (via a thorough research) that the stocks of a hypothetical company - Cow Corp will fetch you good gains in the next few days. Unfortunately, you do not have enough funds. That is exactly where ‘Margins’ or ‘Leverage’ come into play. So, what are these, and how they can help you grow income is what we’ll see today.
Simply put, a stock margin enables you to borrow money from your broker to purchase stocks. While this increases your purchasing power, it also increases the risk of significant losses. Suppose you are bullish on Blog Corp and wish to trade that stock with Rs 10,000. If the Blog Corp is trading at Rs 1,000, you can afford just 10 of its shares. Assuming your call was right, and the stock moves to Rs 1,050. So, your total profit will be 50 x 10 shares = Rs 500. This is how your normal trade functions.
Now see how the same situation with margin takes you to the magical land. Let's say your broker lends you 40,000. So, whatever amount you invest from your pocket is called ‘margin’, your skin in the game and the rest is ‘borrowed money’. So total amount you have is Rs 50,000. Now you can afford 50 shares and your profit becomes 2,500, which was 500 earlier. Perfect! We multiplied our money.
But, if we lose? Uh oh. Your worst scenario can go negative too. When you intend to operate on margin, you are required to open a margin account by paying minimum Margin. The sum in your account should not fall beyond the set limit. If it does, then you will be forced to make a margin call.
You use margin to create leverage. Leverage is the increased “purchasing power” that is available when using a margin account.
Say you want to buy the shares of Blog Corp, at Rs 100. Instead of fully paying the amount, we can simply use the leverage. Then you will be paying only a part of it, say Rs 50 and borrow the remaining. Thus, an increase in price by Rs 50 will bring a gain of Rs 50 or 100% returns. On the other hand, if you had paid the entire Rs 100, the gain would have been Rs 50 or 50% returns. (What just happened? Debt multiplies our risk and reward). Hence, the fall in price will also replicate similar numbers in your loss. Leverage can make the boom times better and the busts harsher.
Many people have been using leveraged money to invest in stocks for decades. In fact, the temptation to invest in the stock market is great these days. But, are these tools right for you? Along with increased purchasing power, they can also be used to diversify a concentrated portfolio. That all sounds pretty good. Before you jump in head first, it’s important to understand the risks. Leverage is a double-edged sword. Going back to our cow example, it’s all great until the cow runs off (impossible! unlikely! But it can!). We suffer and get stuck as we now owe a cow that took off. Just as borrowing on margin can lead to increased gains, it also exposes you to larger losses.
While sophisticated investors may benefit from the increased purchasing power, you need to proceed with caution. Events in 2021 highlighted exactly this. The founder of Archegos Capital Management, a hedge fund turned family office with $20 billion in assets, effectively evaporated overnight due to excessive leverage. (If you are curious, you can read about the entire case in our Archegoes Capital Blog here).
This tactic can be disastrous for those who are not careful. The decision to invest with borrowed money comes down to comparing the cost of borrowing versus the expected investment returns. If the returns exceed the cost, then the transaction makes economic sense.
As the great chairman and CEO of Berkshire Hathaway once said in his 1991 speech at the University of Notre Dame. “I’ve seen more people fail because of liquor and leverage.” Rightly so, but if understood correctly, margin & leverage can work in your favor.
What do you think? Share your views with us in comments section.
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