Financial Gambling And Margin Trading

The growth in the number and size of margin accounts for stocks especially among day traders suggests that many people foolishly neglect these simple truths. From 1996 to 1999, margin debt rose nearly fivefold at on-line brokerage firms and doubled among NYSE member firms. During the decade of the 1990s, margin debt as a percentage of total consumer debt quadrupled from 4% to 16%. Yet many people do not understand that margin loans are not like other consumer loans.nnMargin traders borrow from their brokers at rates ranging around 9 to 11% in order to buy stocks with the borrowed money. They think they can leverage those loans by using the proceeds to buy stocks whose price rises plus dividends yield greater returns. In euphoric markets those people may win, getting returns higher than the cost of the money. In gloomy markets they get crushed.nnWhen the balance in your portfolio falls so that your margin loans are equal to about half or more of that amount, you have to put cash in to pay down that debt. If you don’t have the cash, your broker will sell some of your shares with or without your cooperation. Add the interest expense and the trading costs to a reversal of Mr. Market’s euphoria to count your losses, then multiply that by the number of overextended margin traders and you have the acute slope of a downhill market before you.nnThe big margin traders might as well be high-rolling in Monaco on borrowed money. Look no further than the poster boy of marginized day trading to see the stupefying riskof this strategy. The most vocal proponent of this high-stakes game is Barry Hertz, the impresario of a company called TrackData Corporation. Its marketing pitch gleefully enthused that investing was easy, and Hertz advised his customers to day trade, using borrowed funds.nnHertz at least took his own advice to double speculate. So on Q day, his own brokers called him to say they needed over $45 million to shore up his margin account. To do so, Hertz had to pledge over 50% of his shares of TrackData. Heed the advice of those like Hertz if you like what happened to him.nnFinancial GamblingnnYou would also do well to remember the tragedy of 28-year-old Nick Leeson, the so-called rogue trader working for the Singapore branch of Barings. He funded his trading with millions of dollars of borrowed money, and when the market turned against him, he brought down Barings, the oldest bankin England and the one that financed the Napoleonic wars and the Louisiana Purchase! Leeson ostensibly was doing arbitrage trading, focusing on differences in prices of Nikkei 225 futures contracts listed on the Osaka Securities Exchange (OSE) in Japan and the Singapore Monetary Exchange (SIMEX). He bought futures on one market and simultaneously sold them on the other. This was a low-risk strategy , since the two positions offset.nnIts success led Leeson to another move, a straddle where hesimultaneously sold put options and call options on Nikkei 225 futures. This was a medium-risk strategy , very effective in stable markets but dangerous in volatile ones.nnAn earthquake that rocked Kobe, Japan, in January 1995 plunged the Nikkei and terrorized Leeson. As the market roiled, Leeson acted like a heroin addict and adopted the high-risk strategy of buying more Nikkei futures in the vain hope of propping up the fallen market. When the dust settled, Barings’s exposure on the futures contracts ran to a staggering $1 billion, far in excess of Barings’s total capital. The bankfell to its knees. Investigators discovered that Leeson’s positions had been covered by Baring’s margin accounts while he was trading, but after the crash and after Leeson fled Singapore for Germany they were not. During his trading, Leeson told Barings’s main branch in London the plausible story that he was hedging his long futures positions with private contracts and was also making hedged trades on behalf of a client of the bank. In fact, the client did not exist but was a fictitious name given to an account that Leeson invented earlier for his own use.nnLeeson allegedly funded that account with proceeds from other trades and used those funds to maintain the margin account balance. He apparently used the fictitious client account to convince Barings in London to provide additional firm capital, which Lesson in turn used to shore up the margin account. In the end, none of that was enough.The Leeson lesson is admittedly an extreme psychological case tripped up in a mix of exotic securities, excess margins, and fraud. But the drama is a memorable warning that margins and exotica can get you in over your head and that mixing them can get it handed to you on a platter.