How to work out acceptable amount of margin loan?

Question

I want to make a better return on my investments. One option is to get a margin loan, borrowing money to buy shares. If the price goes up, I'll multiply the gains. The downside of a margin loan is that if share price drops, losses are multiplied. If the price goes down too much then I'll receive a 'margin call' which may force the sale of the shares. This means that I could lose a lot of my investment.

Using margin has always put me off. However, I have mortgaged real estate investments which is basically the same thing, except that the bank doesn't foreclose as long as you keep up the repayments.

I wonder, is there is a safe margin loan, Loan Value Ratio (LVR) to avoid a margin call?

If I bought some Index funds (say a S&P 500) using a margin loan just before the Great Recession, what LVR would have been safe from a margin call?

Answer 1

I wonder, is there is a safe margin loan, Loan Value Ratio (LVR) to avoid a margin call?

There are three factors involved in determining at what price you receive a margin call:

• Initial margin requirement (50%)

• MMMR or minimum margin maintenance requirement (25%)

• the amount that share price drops

The numbers in parenthesis are the levels set by Reg T in the U.S. with brokers having the right to require more. Without knowing these three values, no answer can be provided.

If I bought some Index funds (say a S&P 500) using a margin loan just before the Great Recession, what LVR would have been safe from a margin call?

As an example, if you bought $20,000 worth of your index fund on 50% margin then your loan would be $10,000.

With a 25% MMMR then the MMMR level in dollars would be 4/3 the loan value or $13,333. At that point you would have $3,333 of equity with a position value of $13,333 which is 25%. That means that you were able to withstand a loss of 1/3 of the value of your shares. Given that the market dropped approximately 50% during the Great Recession, you would have received a margin call.

Ask if you want the formula for calculating this at different loan requirements.

Answer 2

You reference the Great Recession specifically, which was the 2007-2009 recession.

The bear market of 2007-2009 lasted 1.3 years and sent the S&P 500 down by 50.9%. - investopedia, A History of Bear Markets

The article also references the 1929 Stock Market Crash, which “sliced 83.4% off the value of the S&P 500”.

There isn’t a ‘safe’ LVR. Even if you maintain enough LVR to withstand the Great Recession’s 50.9% drop, or for that matter, the 83.4% drop in 1929, it is possible for the lender to unilaterally reduce their LVR tolerance even further.

Since markets can only report historical values, future values are always something of a guesstimate. Imagine yourself in the lender’s shoes when the S&P has dropped 50%. Will you be happy to keep the LVR at 50%, or would you rather drop it to say 40% ‘just to be safe’?

If your client borrowed $50 to buy a stock at $100 but that is now at $50 and dropping like a stone, you can sell the stock immediately to recover your $50 (no loss to the lender). But if your client doesn’t want to sell at $50, maybe it would only be worth $40 tomorrow, so there’s maybe $10 of the lender’s funds at risk. To protect your own position, you’d be inclined to require your client to either cough up $10 or liquidate the position immediately.

Maybe the market isn’t going to drop any further, but that’s just an unbankable opinion to the lender looking at a screenful of red indicators.

If you (now as borrower) had borrowed to capacity at a 50% LVR, you’d be in trouble when it dropped to 40%. That’s the case regardless of what materially-useful LVR you pick - it’s when the markets drop significantly that the lender is likely to pull the rug out from under you, to protect their own interests.

There is no LVR level that is both ‘safe’ and ‘useful’.

Answer 3

I never leverage speculative positions but given you essentially magnify/multiply the loss/profit by the amount of leverage you apply the intra-day volatility of the investment vehicle you wish to speculate on is of the utmost importance to my understanding.

To wipe out your position you need to reach an amount of losses equal to original position so at say 20x leverage a mere 5% swing is enough, therefore margin trading say cryptocurrency where 5% swings are like nothing would be a no-no. More "stable" vehicles like S&P may tolerate greater margins given they re much less volatile but in black swan events like the '08 Crisis you would still be wiped out.

All that being said, I imagine you would want to enter positions whereby a small % swing could be stomached, by not going overboard with leverage(so you dont have to gamble at catching the absolute bottoms or tops when shorting) but also keep tight stop-losses so you re not wiped out by a swing that is within the normal distribution for the asset class you re speculating on.