Margin Trading – It Works for Futures and Forex

Margin Trading – It Works for Futures and Forex

Investopedia defines margin as: A brokerage account in which the broker lends the customer cash to purchase securities. The loan in the account is collateralized by the securities and cash. If the value of the stock drops sufficiently, the account holder will be required to deposit more cash or sell a portion of the stock.

Why It Doesn’t Work for Stocks

October 24, 1929-Black Thursday-began a month-long drop in the stock market. It took 25 years, nearly a generation, before the stock market bounced back to pre-1929 levels. From October 25 to October 29, over $30 billion in wealth was loss. At the AXP365 time, the U.S. government’s annual budget was barely $3 billion. This was a disastrous event!

Many investors, because of a looser regulatory environment, had borrowed as little as 10% of the value of the stocks they were trading. Over $8.5 billion was on loan against stocks. This amount surpassed the total amount of currency circulating at the time.

The direct effect of the crash led to tighter rules on stock margin trading as well as the separation of commercial and investment banking. Today’s reality when buying stocks on margin is very difficult. While there are a few exceptions in place for day traders, for the most part you are required to first be approved as a margin borrower; then, you must have at least 50% of the cash available of the stocks face value; and, finally, you must pay interest on the amount of cash you borrow to purchase stocks.

Combine that with onerous rules against shorting stocks, and you find that for a small stock investor it simply may not work using margin to buy and sell stock or to even bother shorting the markets.

Why It Works in Futures and Forex

The only thing the word margin for stocks and margin for futures and forex have in common is the spelling. Other than that, they are two completely different things.

While margin for stocks was intended to be a down payment to ownership of the underlying asset, margin for futures is not. Futures and forex margin represent “earnest” money-basically, a promise to pay. Since we know futures began with tangible products, we also know that the primary users of futures were the actual people buying and selling.

The exchanges were aware of this as well and came up with an elegant solution. Since the buyers and sellers are already heavily invested in their tangible commodities and the futures positions are designed to be a hedge-one side is making money while the other loses money-the exchanges allowed the hedgers to put up a small amount of money as collateral. This was done with implied intent that once the profitable side of the transaction was liquidated, the losses could be easily covered.

With the introduction of the speculator, the concept of margin as earnest money against true cash positions was put to the test. So those that were of sound financial standing were extended earnest money margin, but at higher rates than the true hedgers. Forex margins were developed on similar principals.

As a speculator, futures and forex margin can be very appealing on the surface, but since the margin represents only a fraction of the overall value, profit and losses can have wild fluctuations, and in the case of futures, you can actually lose more than your initial investment.

Don’t Short the Market!

Investopedia defines shorting the market as:

[Selling a security] that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

This is an advanced and often risky strategy. Novice investors are advised to avoid it.

Why It Doesn’t Work for Stocks

Shorting stocks is a difficult enterprise both mechanically and philosophically. Mechanically shorting stocks is not as easy as buying stocks. There are various rules and impedances against the average investor’s shorting stocks, whether it is the one-uptick rule or the fact that you have to borrow stock to short, and there may be no stock available to borrow against to short. There is difficulty after difficulty.

All of these difficulties lead us back to the philosophical problem of shorting stocks. While common sense dictates that what goes up must come down, stocks, besides a few minor setbacks from time to time, are not meant to come down. There are no shareholders, board of directors, or management teams in their right minds hoping to go public just to see their stock collapse. Therefore, when investors purchase stocks, they expect them to go up, and everyone’s hearts, minds, and souls are dedicated to the success of the stock market.

So, realistically, how do you short into an investment vehicle that is not designed for shorting and that also has an overwhelming majority of investors putting their hopes, dreams, and goals into seeing it go up in value? You can’t. That’s why the stock market has created exchange-traded funds to solve those problems. In the meantime, sophisticated investors are turning to the futures and forex markets.

Why It Works in Futures and Forex

Long, short, short, long-it really doesn’t matter. The longs and shorts are treated equally. While there is an inherent long-side bias in the stock market based on expectations, in futures and forex, the attitude is about preparing for the inevitable. Crops can be strong just as easily as they can be weak. The dollar’s value could increase because of economic growth just as it could easily collapse because of a mortgage default crisis.

The goal of the futures market is to act like a fulcrum and keep those who are truly vested in the actual products in an economic balance between long and short until one side prevails. Being able to short with little to no fanfare makes a world of difference in making the futures market function as an insurance vehicle.

This intent bleeds off into helping the speculators. There are no one uptick rules, no borrowing shares, and you don’t have to worry about fighting the philosophy of an entire market.

Anyone new to futures and forex must embrace the short side as easily as the long side; otherwise, you will easily cut your opportunities in half when you initiate a trade. You will then cut your opportunities in half again when you attempt to hold on to a trade in the face of negative pressures, and by the time you realize you should take advantage of shorts, it will be too late. and you will then cut your opportunities in half by ignoring the longs. Long and short, yin and yang. You must be comfortable trading one as well as the other.

 

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