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Buying Highflying Stocks on Margin; An Explosive Combination That Some Firms Now Restrict
uying stocks always is risky. Buying Internet and other high-flying company stocks is riskier still. But buying high-flying company stocks on margin can be as much a gamble as playing the Roulette Wheel. Fortunately, some brokerage firms are beginning to understand that fact and take action to avoid possible calamities - or margin "blowouts".
Let's first review why buying stocks on margin is so risky. First, you buy a stock (say 1000 shares at $50 per share, or $50,000 total) but do not pay for those shares in full (say you pay for one-half and take a loan for one-half). The brokerage firm gives you a loan ($25,000 in our example). Your payment of $25,000 amounts to an equity position of 50% of the current value of the stock.
However, what happens if the value of the shares falls from $50 per share to $30 per share? Most brokerage firms require that you have a minimum equity of 30% of the current value of the stock at all times (Federal Reserve rules require at least a 25% minimum for common stock). This is called the "margin maintenance" requirement. In our example, your loan to the firm of $25,000 consumes all but $5,000 of the current value of the stock ($30,000), thus leaving you with an equity position of only 17%.
As a result, you absolutely must raise your equity level to the required minimums, or else face an immediate liquidation of those shares, and of any other shares that you own, to raise the equity position in your account. If those liquidations are insufficient, you will receive a bill and/or a lawsuit to collect on the "debit balance". This is the downside of margin which most investors do not understand - until it is too late. That is a problem, because it appears that investors may be increasing, not decreasing, their appetite for margin. According to Barron's, margin debt has nearly doubled in the past year to $229 billion.
This margin blowout scenario is all too common with purchasing high-flyers on margin. Let's look at the dizzying volatility of some stocks as measured by their 52-week highs and lows (as of 2/6/00):
| Qualcomm |
$200 high |
$7 low |
| Amazaon.com |
$113 high |
$41 low |
| Ebay |
$234 high |
$64 low |
| Internet Capital |
$212 high |
$7 low |
| Network Solutions |
$288 high |
$49 low |
| Yahoo |
$501 high |
$110 low |
Given that extreme volatility, any capable full service stockbroker or money manager would advise you never to purchase these stocks on margin. However, the discount firms provided no such advice, until recently.
According to the same Barron's article, some discount firms are taking action. Fleet Securities, Datek, Schwab and Ameritrade now impose limits on the use of margin in purchasing highflying stocks.
Discount firm Fleet Securities is the most restrictive. For example, by imposing a 100% margin maintenance requirement, the firm essentially will not let investors use margin to purchase super-hot stocks such as Akamai, Jupiter Networks, VA Linux Systems, Qualcomm and Red Hat. And it has imposed 65% (not 30% as is the norm) margin maintenance requirements on other stocks, such as Broadcom, DoubleClick and Lycos. And much to its credit, Fleet Securities also refuses to make margin loans to investors speculative enough to sell short especially volatile stocks.
The chart below states what margin maintenance requirements the discount firms are placing on the other high-flyers noted above:
| Stock |
Fleet |
Datek |
Schwab |
Amertrade |
| Qualcomm |
100% |
50% |
60% |
No change; 30% |
| Amazon.com |
65% |
40% |
70% |
50% |
| Ebay |
65% |
40% |
70% |
50% |
| Internet Capital |
65% |
50% |
80% |
50% |
| Network Solutions |
65% |
50% |
70% |
50% |
| Yahoo |
50% |
40% |
70% |
50% |
Hopefully, more discount firms will follow the lead of these firms. Taking precautions now will avoid many calamities later.
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Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
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