Buying on Margin and Short Selling FINE 4110, Spring 2023 Buying on Margin • Margin (VOCAB) – describes securities purchased with money borrowed in part from a broker. The margin is the net worth of the investor’s account. • Initial margin (VOCAB) – the starting (initial) percentage of margin in the investor’s account • Set by Federal Reserve Board at 50% (can be set higher by your brokerage) • Maintenance margin requirement (MMR) (VOCAB) – the minimum allowable margin (expressed in %) in an investor’s account • Set by Federal Reserve Board at 25% (can be set higher by your brokerage) • Margin call (VOCAB) – issued by a broker if the margin falls below the MMR; requires the investor to add new cash or securities, or the broker may force the investor to close the position. Buying on Margin • The math can get tricky • Tip: Think of everything in terms of assets and liabilities • Assets = your cash and securities • Liabilities = what you owe • Equity = assets – liabilities = position value – borrowing + additional cash Margin Trading Example • Initial Conditions • • • • Stock price = $70 Initial margin = 60% Maintenance margin = 40% 1000 shares purchased • What is the value of your: • Assets • Liabilities • Equity Margin Trading Example What happens if the stock price falls to $60 per share? • Assets • Liabilities • Equity What is the new percentage margin %? Margin Trading Example With a maintenance margin 40%, of how far can the price fall without a margin call? DIY: Margin Trading You purchase 100 shares at $35 per share. Your initial margin is 50% and your maintenance margin is 30%. • What is your initial equity (dollar amount)? • How far can the stock price fall before you will receive a margin call? • At the point where a margin call occurs, what would your equity be? DIY: Computing Return You have $50,000 in your brokerage account. Your brokerage has a 50% maintenance requirement. You buy 1,000 shares of stock at $40/share. The price goes up to $50. • Computing returns using no margin: • Cash outlay à • Sold shares for à • Profit à • Computing returns with margin: • Cash outlay à • Profit à DIY: Computing Return What if the price goes down to $30? • Computing returns using no margin: • Cash outlay à • Sold shares for à • Loss à • Computing returns with margin: • Cash outlay à • Loss à • Takeaway: Calculating borrowing costs • We need one more piece of information to add borrowing costs to our calculation: time • Say you borrow $20,000 for 50 days • 8% (annual) borrowing costs • First, compute borrowing costs for a year: • How much is that per day (assume 360 days in a year): • Multiply it by the number of days: • This should be subtracted out of your profit when you compute a return (as would any transaction costs) Short Sales • Short sale (VOCAB) – the sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan 1. Short-seller borrows share of stock 2. Sells borrowed stock 3. Purchases share of stock at later date to replace borrowed share (covering the short position) Short Sale Example Initial conditions: • You short sell 100 shares of stock at $60 per share • 60% initial margin • 30% MMR What is the value of your: • Assets • Liabilities • Equity Short Sale Example What if the price goes up to $75? • Assets • Liabilities • Equity • What is your new margin %? At what price will a margin call occur? DIY: Short Sale You sell short 100 shares at $35 per share. Your initial margin is 50% and your maintenance margin is 30%. • What is your initial equity (dollar amount)? • How far can the stock price rise before you will receive a margin call? • At the point where a margin call occurs, what would your equity (dollar value) be? Dealing with Cash Flows Purchase of Stock Time Action Cash Flow* 0 Buy share − Initial price 1 Receive dividend, sell share Ending price + Dividend Profit = (Ending price + Dividend) – Initial price Short Sale of Stock Time Action Cash Flow* 0 Borrow share; sell it + Initial price 1 Repay dividend and buy share to replace share originally borrowed − (Ending price + Dividend) Profit = Initial price – (Ending price + Dividend)
