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Monday, 18 July 2022

The Danger of Margin Trades

8 August 2018

Jump to 

1) Update: 12 August 2018  CFD,  a form of Margin Trade
2) Update: 10 December 2021  Margin Trade today
3) Update: 13, 15 & 17 December 2021  Interest hikes
4) Update: 19 December 2021  Interest rate vs Margin Debts
5) Update: 18 July 2022   The Possible Next Market Move 

Other Relevant Articles

What is Margin Trade?

Simply put,  it is a trade that one borrows money from brokers or bankers to buy stock in the stock market or a currency in a Forex Exchange.  Here is an explanation video

So What is the Danger?

Actually,  there is nothing dangerous about Margin Trading.   It is just a financial tool that investors can use as leverage to buy more stocks or currencies.

There is a danger only when the investors become very greedy,  starting to trade margins above their means,  borrowing more and more margin until they cannot pay up when the brokers or bankers initiate a "margin call".

What is a Margin Call?

A margin call happens when a broker demands that an investor deposits more money or securities so that the margin account is brought up to the minimum maintenance margin. A margin call often happens when there is a market crash and the account value falls below the broker's required minimum value.
When there is a margin call,  the investors are often given little time to do the "top-ups".   In the event that the investor cannot top up the account within the stipulated time,  his brokers or bankers will have to right to dump all his stocks or currencies in the market at ridiculously low prices to recover their losses.

Why do I have to worry?

Rightly, one need not worry much if one does not “play” margin trades;  however, one would have to worry when the margin trades in the market are running out of every proportion with a possible risk of causing a market failure.  This is when margin debts will be so high to cause en-masse margin calls that will cause markets to collapse.

Can Give Example?

1.  The SGX’s Penny Stock Market Crash in 2014

A Malaysian businessman and his partners manipulated the market and caused the price of 3 Nos of SGX’s penny stocks;  namely,   Blumont Group, LionGold Corp, and Asiasons Capital,  to surge by more than 800 per cent in less than 9 months in 2014.   A Singaporean trader by the name of  Quah Su Ling took up a margin loan of a very big amount from Goldman Sash London.  When the price of the 3 penny stocks fell on Oct 2,  2014,  Goldman Sash demanded  Quah to top up $48 million in her margin account within one and half hours and started selling her stocks.  Over the next 2 days,  $7 billion were wiped off from the 3 SGX’s penny stocks.  Blumont and Asiasons’s share prices dropped from a peak of S$2.0 to less than 1.0 cents in weeks.   This caused the SGX's penny stock market to crash.  The details are covered here

2.    Stock Market Crash of 1929 - Buying on Margin

It was speculated that Margin trades were partly responsible for the stock market crash of 1929.

What’s the Present Situation?

The following chart prepared by “ Perspectives” illustrated what is the present situation of Margin Trade in the US market.

From the chart,  one can clearly see that the margin debts peaked and then fell in the last 2 market crashes in 2000 and in 2008.   The  2000 crash occurs when the margin debts reached about 170% while S&P climbed 75% from 1997.  There is a 100% point difference between the margin debt and the S&P growth.  As for the 2008 crash,  this point difference is about 150%.   Presently,   this point difference is getting even larger at about 175% as of July 2018.   There is no definite proof that a market crash is imminent but at this level,  the risk of a market crash would be high.

How Bad will be the present Market Crash?

It is anybody’s guess.   Many have speculated for a crash to happen in mid-2015 when Margin Debt was as high as 250%.  But this crash did not happen and stock markets continue to ride higher after Trump was elected and promised to make “America Great Again”.
The following chart will show the risk of market failure is much higher than those in 2000 and 2008 because the investors have choked up 3 times as much as a credit balance to do margin trades.
(Note that the investor credit in 2008 was among the lowest because there was a liquidity crisis in 2008 where banks almost run of money.  Investors must have been using their assets rather than their money to maintain adequate balance in their margin accounts.)

Why Government Did Not Ban Margin Trading?

Most Governments realize the risks of margin trading but could not always control and contain it as it will affect stock market functions.   China experienced the worse market crisis in early 2015 when Shanghai Composite plunged about 8% in a single day.  Then the  Authority was trying to clamp down on margin tradings and risky lending practices used by China’s biggest securities brokerages.  The market has not recovered fully even 3 years after.

In Conclusion

In the 2008 stock market crash, 7.0 trillion USD was wiped off. In the 2000 crash, 8 Trillion USD disappeared within weeks. This coming financial crisis could be even larger.  

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Update: 12 August 2018

Is CFD a form of Margin Trade?

CFD is an abbrev for  “Contracts For Difference”.   Many treat it as another form of Margin Trading except  for the following

1.  One will need much less capital outlays because of the very high margin or leverage in the trade.   For example,  when one takes a normal margin loan,  one will need to come up first with about 40% of the capital investment with a 60% loan.  For CFD,  the capital investment may just be 5%;

2.  The risk will be much higher due to the high leverage;  one can easily lose 100% of one’s capital;

3.  In CFD,  there is no ownership of the stocks or the underlying assets.   In normal margin trading,  one still owns the rights to the stocks such as voting,  dividend,  corporate action, etc;  however,  the brokers or the banks are given the right to sell the stock to recover their losses, if any.

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Update: 10 December 2021

What is the present position of Margin Trade?

The market is again reaching a testing point after the last market hoax in 2018 where we saw DOW Future losing about 25% or  6,000 points from 28,000 to about 22,000.    Then the market was spooked by "heightened trade and geopolitical tensions".    There were not many concerns about such a crisis having any impact on inflation and therefore,  did not attract any monetary policy response.  

If a market crash were to happen in 2021 as expected after much speculation,  it could be a different picture altogether.   First,  the market has had no appreciable or reasonable market correction in the last 10 years between 2009-2019;  instead,  we saw the market's rising rate double from 5% per month to 10% per month in the short span of 21 months between 2020 and 2021.  

Rightly speaking,  the market could have continued its way up at the pace if the inflation can remain as mute as before but the last inflation rate of 6.8% has prompted market speculation that Fed is going to increase the interest rate soon to tame the inflation.  This will not be good news to those investors who have been "living" in the past using margin trades to earn a living.   The margin trade business has gone sky-high with a rising rate about the same as the stock market for the period in the last 2 years.   We should see the margin traders will start to sell their stocks as they will no longer be able to hold the increasing margin rate with the market price falling every day when there is a market crash. 

What caused the Present Inflation and Why the concern?

Many speculated that the monetary easing especially the recent one has caused this present inflation rate to rise. They are not wrong as can be seen from the following M2 money supply chart.   The chart is showing us clearly that the growth of the M2 was gradually rising over the past many years except for the last 2 years when we can see a sudden jump.   This signifies that there was an injection of cash or equivalent causing market inflation to rise.    This is because the M2 money supply is measuring the money that mostly flows within the community;  for example,  cash, and checking deposits and is easily convertible near money.   

Inflation will always attract Fed to take action in the past.   They would either raise interest rates or tighten monetary policy which would affect not only the stock market but also the rich people.

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Update : 13, 15 & 17 December 2021

When will Fed Tighten its Monetary Policy? 

Fed has been using monetary policy in the past to fight inflation.  This is because reducing the amount of money in circulation will curb consumer spending,  and that will, in turn,  lower the rate of inflation.   The question is when?

The speculation in the market is for Fed to raise Federal rates before September 2020.   Wells Fargo expected 2 rate increases in 2022 and another 3 in 2023.  That was a few weeks back.   

Update 15 December 2021

Update:  17 December 2021

BOE's unexpected hike of interest rate to 0.25% from 0.1% could send shock waves in the stock market around the Globe,  especially when most stock markets today are propped up by borrowed money such as Margins, etc

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Update:  20 December 2021 

The following is a chart showing the Margin Balances collected by FINRA for the various months since 1997.  The chart is showing the long-term trend lines of  Margin Balances and the US long-term interest rate are moving inversely over the period;  however, one cannot say so for the short-term movement. This may be because some investors were seeing opportunities, for example,  to borrow more money to buy stocks when others were dumping the stocks.   It may be also because the investors did not feel the pain as the interest rates were rising in small steps of 0.25 percentage points each time.  


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Update:  18 July 2022  The Possible Next Market Move 
The following charts will show that the Margin Debts in the US market have dropped to a level that could have triggered the urge to restart the engine for the US market.

One will easily notice that the curve of margin debts tended to run below and follow behind the trend of the S&P500 until the year 2005/06 for some reason probably due to a change in the SEC rules.  Since then,  margin debts have always been running and leading the S&P500.

It is interesting to observe the following:- 

Figure 5

a)  Margin debt is always a leading indicator for market crashes;  it will fall before the market index started to fall;

b)  Except for the bubble in 2000 and before the SEC rules were changed,   the margin debt will rise first,  followed by the market and also when margin debts almost reach and touch the S&P500;


Figure 6:

1)   The chart shows that margin debt is no longer the main source of the "driving force" behind the market.  The investors could have found and used other sources to drive up the market, especially when such changes occurred after the latest round of QE which is also driving up US inflation at the same time;

2)   Nonetheless,  the curve of margin debt as % S&P has just hit support again.   It might have indicated that the market could have recovered provided there is no further aftermath event like Lehman Brothers in 2008 causing secondary damages to the stock market and Fed is able to control its monetary policies to avoid a hard landing.

Disclaimer:  This article is for information and educational purposes.   Readers are advised to conduct their own research and study to make their own investment decisions.

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