Buying Stocks on Margin in the UK - dummies

By David Stevenson

As a private UK investor you can’t run a private equity fund, but you can use a margin account to take advantage of leverage. Most stock brokers willingly set you up a margin account that lets you borrow money at a pre-agreed interest rate; generally you can borrow up to 50 per cent of the cost to purchase stocks.

Assume that you have £100,000 to invest and you use it to buy 500 shares of a £200 stock. If the stock’s price goes up to £250 in 12 months, you end up with a £25,000 gain and a 25 per cent return. That’s known as your unlevered return.

With leverage, however, you still have £100,000 to invest but your broker allows you to borrow up to 50 per cent of any stock purchase at an interest rate of 10 per cent. Now you can buy 1,000 shares at £200 per share, for a total investment of £200,000 (£100,000 of your cash plus that £100,000 margin loan).

The stock goes up in value to £250 over 12 months as before and you sell up. You get back £250,000, pay back your loan of £100,000 plus 10 per cent interest (£10,000) and you have £140,000 in your hand ‒ a pretty nifty 40 per cent return.

Asking the question: Isn’t gearing up risky?

Using leverage ‒ in effect, using other people’s money ‒ is almost self-evidently risky and apparently today’s world is a slightly grim place in which everyone’s deleveraging like crazy. Or at least that’s what some stock-market analysts think.

For debt cynics like Gary Shilling (author of The Age of Deleveraging), and he’s far from being a lone voice), debt is bad and cash is good.

A warning from history

Leverage has certainly gone horribly wrong in the past, especially when applied to investing in shares using margin accounts. The orgy of margin buying during the 1920s’ boom helped precipitate the Stock Market Crash of 1929 and the resulting depression as thousands of investors couldn’t make their margin calls. Back then, margin requirements were quite lenient and investors were able to purchase huge blocks of stock with very small upfront investments.

When the stock market began its deadly spiral in 1929, scores of investors received margin calls. They were forced to deliver additional money to their brokers or their shares would be sold.

Because most individuals were leveraged to the hilt, they didn’t have the money to cover their leveraged positions, which forced brokers to sell their shares. The selling precipitated further market declines and more margin calls . . . and so on. And everyone knows what happened next.

The brutal truth is that, although leverage can certainly help to gear up your returns, any losses are also correspondingly greater. If you invest £25,000 of your own money and your portfolio drops in value to £15,000, after 15 years, you’ve lost £10,000. But if you borrowed £25,000 to purchase that same portfolio, you’re out of pocket by much more.

If, for example, you paid for your investment by taking out a home equity loan with a 15-year term at 6.5 per cent, you’ve also paid £14,200 in interest. In this case, your total loss is £24,200 (£10,000 + £14,200) ‒ almost 150 per cent more!

Using leverage shortens your time horizon and doesn’t give you the long-term time to bounce back. Also, come what may, you still have to pay the interest on the loan, even if your investments are falling in value.

Few events are worse than receiving a margin call from your stockbroker. A margin call is when your broker demands that you deposit enough of your own cash into the account to bring the balance up to the minimum maintenance margin requirement.

Investors must put up a minimum initial margin of 50 per cent, but they also need to always run a maintenance margin of at least 25 per cent. This margin protects the broker if the value of the investment declines. If your value of equity in shares or bonds drops below that 25 per cent barrier, your stock broker needs to make the margin call.