What is Equity Margin Lending?

Margin loans are more suitable for investors with a clear understanding of leverage and those who are fully aware of its process and the risks that it comes with. BlockLoan is offering a crypto equity margin lending model. However, if you’re not yet aware of how margin lending works, as well as its risks, it may be best that you first speak to a professional or a licensed financial adviser who can advise better.

How Margin Lending Works

Whenever you purchase shares on a margin loan, the provider will lend you some portion of the proceeds to fund your purchase and will use your shares as security against the loan. Therefore, the lender could sell your shares to take the loan back if you can’t meet the margin call.

Since the share prices are highly volatile and tend to move frequently, you’ll be unprotected from the possibility of the shares declining in value. How much leverage you’re taking will mainly depend on the LVR or Loan Value Ratio, and this is the amount of loan divided by the total amount of the shares. For instance, if you’ve got an LVR of 70 percent, then you are borrowing 70 percent of the share value.

Margin lending providers like BlockLoan have varying maximum LVR on the different stocks depending on the volatility of the underlying stock price. For instance, you can expect to receive higher LVR for stocks like the CBA or Commonwealth, versus stocks that are more volatile, like the FMG or Fortescue Metals.

Example of a Margin Loan

For example, you have invested $100,000 in Stock XYZ, and you have decided to borrow another $50,000 to invest because you feel that XYZ is cheap and the dividend and franking credits could cover the cost of the margin loan.

If you take this loan, you’ll now have $150,000 in stock with XYZ. And since you borrowed $50,000, then your LVR will be 33%. That is computed as follows — $50,000 ÷ 150,000. If XYZ falls to the point where the loan value will exceed the maximum LVR, you’ll get a margin call, and you’ll be required to bring the LVR back into an acceptable level which you can do with any of the following:

• Provide the lender with additional security, which could be in the form of another stock from your portfolio.
• Top it up with cash.
• Sell some parts of your investment and use the cash to top-up.

Risks Associated with Margin Loans

You should be aware of certain risks before you decide to take out a margin loan:

• Terrible losses in the event of a market crash, which forces you to pay more cash to service the loan or you may have to sell the stocks at the worst time.
• Receive margin call unexpectedly as a result of the lender lowering the maximum LVR. This could happen due to some reasons, including the volatility of the stock markets.

If you need more advice regarding the risks involved in leverage and margin loans, it may be best to speak with a professional and accredited financial adviser.

Managing Your Margin Loan Risks

• Be conservative with your gearing

You don’t need to borrow a maximum amount. By keeping your LVR low and gearing conservatively, you’ll be able to reduce the risk of forced selling during the worst possible time, where the market is bottoming.

• Diversify your holdings

If you diversify your holdings by having several holdings across various markets and industries, you’ll be able to minimize your concentration risk and lessen the possibility of your portfolio falling in value at the same time.

• Check your loan to value ratio

It’s important that you know your LVR and the risks present in your portfolio. That way, you will not receive any horrible margin call that could surprise you.

• Have funds ready for a margin call

Remember that margin calls could happen anytime, and if you’ve got cash or additional security ready, you’ll minimize the need to have to force-sell your assets at short notice.

• Hire a good adviser

If you’re not exactly sure how to monitor your margin loan and the risks involved in it, you can ask for help from a good financial adviser. A well-experienced adviser is capable of monitoring your portfolio and will provide you with general advice on how to keep your portfolio under control.

Finding Your Margin Investment Sweet Spot

Investing is often seen as a balance between fear and greed and margin investing is about both. Not considering the tolerance of individual risk, how low should the interest rates go before an investor can create a solid case as a result of using another people’s money? Is there a sweet spot? We’ll show you how you can find one.

Margin Investing Logic

Modern portfolio theory suggests that a great way to invest is to look for a balance between lending and investing. There are usually two extremes when it comes to this — to minimize the risk of investment, one must invest purely in T-bills. However, if the investor seeks for a much bigger return, he could invest more in the stock market. But there’s an even higher option for return — borrowing from a stock portfolio and then investing the proceeds in more stocks, a process known as margin investing.

Not considering the volatility, a case can be made to borrow and reinvest the money once the rate is low enough plus the investor is capable of bearing the risk. It’s pretty understandable that the investor must be rewarded with more return since he’s taking over an added risk. From here, the investor would assume that as the rates will go low, the Fed will indirectly be lowering the lending rate to urge people to keep on investing in companies by reducing the attractiveness of a safe haven investment.

Let’s examine this and take a closer look if your investment options have widened.

Model Portfolio

Like any example, we need to assume certain things. Undeniably, investing is risky and requires both a psychological tolerance and the financial ability to endure the price swings and the volatility of the market.

To make our theory work, we have to clarify our assumptions in this example.

• Investors will only manage against margin call risk. This is the type of risk where underlying stocks depreciate to less than 50 percent of the equity position.
• The investor’s goal is to maximize wealth.
• A hypothetical investor is affluent having $1 million of diversified investable assets. Thus, there’s no longer a need for current income and has a combined marginal tax rate of 40 percent.
• Margin rates are approximately 2.5 percent higher than our interest rate proxy, a 5-year Treasury note.

What Does History Suggest?

Those who often ignore history have the tendency to repeat it. Between the years 1965 and 2008, we see the interest rate proxy going less than 4 percent only twice -one time in 2003 and another in 2007. Since we are yet to see the full effect of the current market rate cuts, the best thing we can do is to look at the market return over the last 5 years, which is more than 50% cumulative or about 9% annually on an average. Therefore, the benefit is quite easy to see. But let’s keep looking at this since the interest rates tend to bounce around many times.

Margin Loan vs. Property Investment Loan

The biggest difference between the margin loan and a loan that’s obtained for property investment is through the security held. The standard loan of investment is usually held against the property being bought or the equity of the borrower’s home, while the margin loan will have to be secured against the total value of the shares bought. This difference in the security held does change the associated risk that comes with the loan, where the shares and managed funds are being priced daily, and the fluctuation in the value of the security is more likely to happen, and this could result in a margin call.

Playing with Fire or Warming Yourself?

Margin investing is like fire. It could keep you warm and profitable, however, once it goes out of control, it could end up burning you. This is why margin investing is usually for the disciplined and more sophisticated investors only.

The biggest risk that margin investors are managing against is the risk that the loan could be called out and the investor could end up selling securities in a bad market, which keeps the investment strategy from running its course. This is why keeping the underlying assets to be as diverse as possible is extremely important.

For the sake of the given an example, we’ve already assumed this. Considering the market’s average return, we assume that this is roughly based on an 8 percent appreciation and 2 percent dividends after tax and the overall return is at 7 percent.

Margin interest expense is usually tax-deductible. Thus, a 40 percent effective marginal tax rate could significantly cut the expenses. Assuming the margin rate is at 6.5 percent, you’ll see that the after-tax cost of the margin interest is: 6.5 percent x 60 percent = 3.9 percent. The spread made from the borrowed funds is as follows: 7 percent minus 3.9 percent = 3.1 percent, which is not that bad.

Is Risk Calling?

Let’s take a closer look at call risk. Here, we will take into consideration the major crashes in the market. A severe market crash could significantly erase the market value in just one day. Therefore, it’s a good idea to allow a 30 percent backslide to mitigate any margin call, which leaves the margin balance up to 70 percent of the overall equity value. Anything more than this will already be considered playing with fire instead of warming your investment portfolio.

But this is not really a hard rule, assuming that you can still sleep well at night and fit in the other criteria. Margin investing is sometimes a logical choice. Therefore, since the range is 70 to 100 percent equity value in margin investing, then your sweet spot is perhaps a target of 85 percent. From here, you should be able to pay down debt if the market will fall and the rates go up. On the other hand, you can invest if the opposite holds true.

What’s Margin Call?

Margin call happens if a broker demands that the investor deposits more funds or securities in such a way that the account will be brought up to the minimum maintenance margin. The margin call will occur if the account value falls below the required minimum value set by the broker.

This basically means that one or more of the securities held at margin account have decreased in value at a certain point. As a result, the investor should either deposit more money into the account or sell some of its assets.

Example of a Margin Call

An investor purchases $100,000 of the company’s stocks using $50,000 of his own money and then borrows from the broker the remaining $50,000. The broker of the investor will have a maintenance margin of 25%. During the time of purchase, the investor’s equity in percentage is 50 percent.

Investor’s Equity as Percentage is computed as follows: (market value of the securities less the borrowed funds) ÷ market value of the securities.

From the example above, it will be:

50% = ($100,000 minus $50,000) ÷ $100,000

This is more than the 25 percent maintenance margin. However, if on the second trading day, the value of the purchased securities will fall to $60,000, this will result in the investor’s equity of $10,000.

16.67% = ($60,000 minus $50,000) ÷ $60,000

This will now be less than the maintenance margin of 25 percent. The broker will make a margin call and will ask the investor to deposit at least $5,000 to meet the maintenance margin. The amount needed to meet the maintenance margin is computed as follows:

Maintenance Margin x Market Value of Securities = Investor’s Equity

From our example, the required $5,000 will be calculated as:

$5,000 = ($60,000 x 2 percent) minus $10,000

Thus, the investor will need at least $15,000 worth of equity in his account, so he will be eligible for the margin. However, he only has $10,000 in the investor’s equity, which results in a deficiency of $5,000. The margin call will be for $5,000, and if the investor does not deposit this amount in time, the broker will liquidate the securities for the value that’s enough to bring the account in compliance with the maintenance margin requirements.