Marginability

Most day traders make money through a large volume of small profits. One
way to increase the profit per trade is to use borrowed money in order to
buy more shares, more contracts, or more bonds. Margin is money in your
account that you borrow against, and almost all brokers will be happy to
arrange a margin loan for you, especially if youre going to use the money to
make more trades and generate more commissions for the brokerage firm. In
Chapter 14, I discuss how margin is used within an investment strategy. Here,
though, you want to think about how margin affects your choice of assets for
day trading.
Generally, a stock or bond account must hold 50 percent of the purchase
price of securities when you borrow the money. So if you want to buy $100
worth of something on margin, you need to have $50 in your account. The
price of those securities can go down, but if they go down so much that the
account now holds only 25 percent of the value of the loan, youll get a
margin call.
Margin requirements arent set by the brokerage firms. Instead, the minimum
amount in your account and thus the maximum amount you can borrow
is set by the Federal Reserve Board. Thats because of concerns that if too
much borrowing takes place, the borrowers will panic in a financial downturn
and drag the market down even further. (Excessive trading on margin was a
contributing factor to the stock market crash of 1929, in which the Dow Jones
Industrial Average fell 13 percent in one day, and the market did not fully
recover until 1954.) The Fed limits the amount that can be borrowed, and the
different exchanges monitor how member brokerage firms comply. Some bro-
kerage firms set margin limits that are higher than those of the Federal
Reserve Board and the exchanges.
You probably think that the 1929 crash was responsible for the Great
Depression of the 1930s, right? Think again. Most economic historians believe
that the crash was a distraction. Instead, the real problem was that interest
rates fell so rapidly that banks refused to lend money, while prices fell so low
that companies had no incentive to produce. Its a situation known as defla-
tion, and its relatively rare, but it is devastating when it occurs.
Most stocks and bonds are marginable (able to be purchased on margin), and
the Federal Reserve Board allows traders to borrow up to 50 percent of their
value. But not all securities are marginable. Stocks priced below $5 per share,
those traded on the OTC Bulletin Board or Pink Sheets (discussed later in
this chapter), and those in newly public companies often cannot be bor-
rowed against or purchased on margin. Your brokerage firm should have a
list of securities that are not eligible for margin.
53
Chapter 3: Signing Up for Asset Classes
07_171493 ch03.qxp 9/25/07 4:39 PM Page 53