Margin calls rock the market
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There are, of course, a thousand things that can put pressure on stocks.
Sometimes they’re pretty straightforward, like today’s report on retail sales.
But often the reasons stocks decline are more obscure. One of those obscure ones we’ve been hearing a lot about lately is the margin call.
Here’s Bill Radke with the latest installment in our explainer series the Marketplace Decoder.
Let’s say it’s 2007. The stock market keeps going up and up; the Dow is at an all-time high. And you go to a party.
Tom: Is this the line for the bathroom?
Tom: Thanks, I’m Tom, by the way. I’m an average radio listener.
Sara: Hi Tom I’m Sara. I’m a stockbroker.
Tom: Oh man, I wish I could buy more stocks. But I don’t have enough cash.
Sara: Oh, I’ll lend you some money.
Tom: You will? Just like that? Don’t I need to put anything down?
Sara: Yeah, you put some down, I’ll lend you the rest and I’ll use the stock you buy as your collateral.
Tom: Well, gee, what could go wrong? OK!
Congratulations–you’re about to buy on margin.
Now, Sara the stockbroker is smart.
She’s going to make sure there’s a cushion between what your stock is worth and what you owe her. That cushion is your “margin requirement.” Think of it as your margin of error: Your stock can only go down a certain amount before you get a call from Sara.
Sara: Hello, your stock has gone down. This is your margin call.
And that means she wants more collateral. That could be cash, stocks, whatever she’ll accept. You pump that into your margin account, re-inflate that cushion, and you hang on and hope your stock goes back up.
But, what if the market keeps going down? You and other investors keep getting margin calls and the securities you’re selling to cover your margin keep dropping in value, which means more margin calls and more losses.
Doug Grantz: And now that can accelerate the decline.
Doug Grantz is with the investment group Research Affiliates.
Grantz: If your whole basket of stocks that you would use as collateral is going down in value, you might not have the opportunity to pay the margin call to keep your stocks and therefore the broker would have to sell them, furthering fuel for a declining market.
Radke: And down we go.
Grantz: Continually, yeah. It kind of gets a momentum to it.
And that is how margin calls can sometimes make a bad stock market worse.
In conclusion: When you buy on margin, you’re leveraging. If you bet right, you magnify your gains. And if you bet wrong, your losses are magnified, too. So, if you want to play the market with borrowed money–by all means, buy on margin. Just make sure you bet right.
I’m Bill Radke for Marketplace.
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