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Daytraders Fret When Margin Comes Calling

An increase in margin calls could cause distressed selling for some ambitious online players.

In hushed tones but with increasing frequency, market players are now discussing one of the most dreaded phrases on Wall Street: margin calls.

If action last Friday and Wednesday proves not to be a reprieve from recent weakness, especially in Internet stocks, expect to hear more about the once-unspeakable subject.

That's because the level of margin debt has risen sharply in recent months. At the end of April, total margin debt extended by

New York Stock Exchange

member firms equaled $172.88 billion, according to the

Federal Reserve

. That's revised down from an earlier reported $181.9 billion, but it's still the highest level ever and, perhaps more importantly, it's up 18.2% since February and 22.6% since the end of 1998. Meanwhile, some online brokers reported margin calls were running as much as 50% higher than normal early last week,

The Wall Street Journal

reported.

Margin Debt on the Rise
Margin debt levels extended by NYSE members, in millions of dollars

Source: Federal Reserve

Of course, it's important to note that while the absolute level of margin debt has shot up, the overall level of market capitalization has skyrocketed so much in the bull market since 1982 that margin debt has come to represent a smaller percentage of market cap. And market regulators appear sanguine about the issue at this point.

Securities and Exchange Commission

Chairman Arthur Levitt seems more concerned about the content of commercials aired by online brokers, and an SEC spokesman deferred to the Fed on the margin issue.

Fed officials decline to comment, although one person at the central bank says: "This is something people involved have noticed, but it's not something that's going to have any bearing on policy."

For the uninitiated, investors incur margin debt when they borrow money from brokerages to purchase stocks (or bonds, or commodity futures, etc.). If the assets fall below a predetermined percentage of the value of the portfolio -- the

Federal Reserve

sets initial margin requirements at 50%, but some brokers require more -- a margin call results, in which the individual needs to come up with cash to cover any shortfall.

While unpleasant, a margin call might not be onerous to an investor with cash on hand or a diversified portfolio. However, many online traders and daytraders are believed to be overly enamored with tech stocks in general and Internet stocks specifically, and thus may not have "winning" stocks in other areas to sell to cover losses.

Worst-case scenario: Say an investor bought

Yahoo!

(YHOO)

on margin back on April 6, when it traded as high as 244. He might have faced a margin call on Wednesday, when it traded as low as 120 1/2. If his portfolio was overloaded with tech stocks, he might have been forced to sell some

Dell

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or maybe

TheStreet Recommends

Lycos

(LCOS)

to cover the margin call. Otherwise, he'd risk having the broker liquidate his holdings.

Such "distressed" selling of Dell and Lycos puts pressure on those stocks, which might trip margin calls for our investor's online trading friends and neighbors. This cycle then feeds on itself and presents a harrowing theoretical picture of what happens when good momentum goes bad.

"Once again, the talk is of the potential of one huge margin call for the daytrading community that has been playing Internet stocks so aggressively," David Tice, manager of the

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Prudent Bear fund wrote Wednesday evening. "Possibly, as has been the case in the past, a rally will let the Internet speculators off the hook. One of these days, however, a major break could arrive that will wipe many traders out."

Of course, Tice's bearishness has been anything but prudent in recent years, and tech stocks could rebound sharply and swiftly. But the critique seems to have some juice now as the high-tech stocks get squeezed across the board.

TheStreet.com Internet Sector

index was down 26.5% from its all-time high of 790.44 heading into Tuesday's action, while the

Nasdaq Composite Index

was off 6.8% from its record best of 2652.05. Those highs were established on April 12 and March 26, respectively, so it's not unfathomable to think investors were ratcheting up margin levels just as the indices were peaking. Therefore, some investors are tasting the pain with every tick below those levels.

Margin Fright, Daytraders' Delight

Tice singled out daytraders as a potential source of trouble, despite admitting in an interview, "We certainly are not experts on the daytraders and how much margin power they're using. ... I do think the whole phenomenon where aggressive players in the most aggressive stocks likely are using aggressive tactics such as margin. To a degree, aggressive behavior has paid,

but when that reverses, it reverses in spades."

Meanwhile, one hedge fund manager says some daytrading shops are allowing clients to "piggyback" on their institutional margin capabilities to leverage up much more than the Fed-mandated 2-to-1 level.

"I've heard several major firms are extending" margin beyond the Fed limits, says Harvey Houtkin, CEO of

All-Tech Investment Group

, although he offered no proof or specific examples.

While reiterating his firm's compliance with the 2-to-1 requirement, the daytrading entrepreneur defended the industry and its participants, suggesting "suitability" should be more a concern in regard to margin abuse.

"An active trader is less likely to get caught with a margin call than a guy who buys a 1,000 shares of

Amazon.com

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and looks at a paper a week after because he went on vacation and finds he got wiped out," Houtkin says.

A problem with margin is "more germane for the online trading community, where the only requirements are $1,000 and a heartbeat."

Regardless of who gets them, margin calls could cause some of those hearts to skip a beat, and perhaps are contributing to the market's own uneven EKG reading.