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Article Archive >> Business

Financial Focus/Using Margin Accounts for “Hot” Stocks? Don’t Get Burned

Baseball Hall of Famer Yogi Berra is supposed to have said: “It’s deja vu all over again.’’ This saying may have particular relevance to today’s investment scene - with some potentially unfortunate consequences.

Over the past several months, investors enjoyed the appreciation of many stock prices - just as they did in the months before the stock market “bubble” burst in 2000. And some investors are buying these risky, volatile “hot” stocks on margin - that is, they are borrowing money from their brokers to pay for these stocks. Margin account balances grew rapidly this year - similar to the way they did in 1999 and early 2000.

Why does this recent investment history seem to be repeating itself? Let’s look back to the technology stock boom in the late 1990s. When prices soared, investors learned that they could make money over a relatively short period of time. As we now know, many of these investors got burned. Yet, some of these same people believe they learned from the experience, and that they can now make money trading “hot” stocks. They are so confident that stock prices will rise that they are willing to buy these stocks on margin.

Of course, margin trading is risky, because it frequently involves the trading of volatile stocks. For margin transactions to be profitable, stock prices have to rise high enough to cover the commissions charged on the purchase, the commissions charged at the sale and the interest the borrower is charged on the loan. If the margined stocks are not sold at their high points, the profit is quickly eroded by these charges.

As an investor, can you pick the right “hot” stock? Can you control the impulse to “ride a stock up” in an effort to wring out every possible dollar of profit? Can you tell the difference between a temporary “dip” and the beginning of a significant price drop?

And, perhaps the most important question is: Can you come up with the funds immediately to meet a “margin call”? You might face a margin call if the value of your collateral - the stock in your brokerage account - no longer meets the requirement for the amount of money that you borrowed. Typically, a brokerage firm will lend you 50 percent of the value of stock that you purchase. If the price of the margined securities falls too far, and the equity in your brokerage account slips below a certain level - generally, 30 percent to 35 percent of the value of the account - you may get a “margin call” from your brokerage firm.

To meet this margin call, you may have to liquidate some investments - but if the market is declining, it’s a bad time to be selling stocks. So, if you’re going to be a margin trader, you need to have reserve funds available to outlast a drop in stock prices. And you need to know when to cut your losses.

Margin trading has its rewards - but it certainly comes with some hazards. To trade on the margin, you need patience, discipline and the right disposition - and, as we’ve seen, you need to have enough liquidity to face an unpleasant margin call. In short, margin trading is not a good strategy for those people who think they can make money quickly on hot stocks.

Ultimately, you need to ask yourself this: Are you an investor or just a trader? There’s a big difference between the two.

This article was submitted by the financial representatives of Edward Jones in Hagerstown: Greg Garner AAMS, 301-733-9465; Dave Walker, 301-766-7300; Joan Bowers, 240-420-8514; John R. Pullaro, 301-824-7726 and Todd Streett, 717-762-0911.

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