I spent the better part of my career at Merrill Lynch ( MER) as a vendor of leverage primarily to hedge funds . You might recall one of them by the name of Long Term Capital Management. LTCM was a master of the use of leverage, which also led to its undoing.

So what is leverage? Leverage comes in many forms. If you've ever bought a house and took out a mortgage, then you've used leverage. In this installment of the Finance Professor, I will shed some light on leverage from the point of view of buying or gaining exposure to stocks or stock indices.

Buying stock with borrowed funds is achieved through the extension of credit from a broker-dealer or other financial institution . Such credit arrangements are regulated by the Federal Reserve through a series of regulations -- Regulation T, Regulation U and Regulation X. Of those rules, Regulation T contains the guidelines that govern the extension of credit by broker-dealers to customers, particularly individual investors who purchase and carry securities. To many people, Regulation T is simply referred to as the "Margin Rules."

The Margin Rules

There are many aspects to the margin rules that you must understand before buying securities on credit. I will discuss those rules in the context of stocks.

  • Cash Account: An account in which all securities are paid for in cash and no extension of credit has been made by the broker-dealer to the customer.
  • Margin Account: An account in which securities have or can be pledged to a broker-dealer for a margin loan. Retirement accounts cannot be margined.
  • Margin Agreement: A document that spells out the terms under which the extension of credit is made. Furthermore, the client will pledge the securities as collateral under a hypothecation agreement, which creates a lien against the securities in the margin account.

    The hypothecation agreement will also permit the broker-dealer to borrow shares free of charge to secure its own loan ( rehypothecation ). Be careful, because buying stock on margin can help feed a short-seller's need to borrow stock and shoot against your investment.
  • Margin Securities: These are securities that are eligible for extension of credit under margin agreements in margin accounts. There are regulatory definitions that outline the requirements for a security to be considered margin-eligible. In addition, individual broker-dealers may place even more-stringent requirements upon certain securities above the regulatory minimum.
  • Minimum Margin: This represents the minimum amount that a broker-dealer will require a customer to deposit in order to establish a margin account.
  • Initial Margin: This is the amount of money that you can borrow for the purchase of a stock. According to Regulation T, this initial amount is 50%. Thus, if you desire to purchase 100 shares of Goldman Sachs (GS) at $200 per share, of the total purchase price of $20,000 the investor can borrow no more than $10,000 (50% of $20,000) at the time of purchase from the lender.
  • Margin Loan: Sometimes referred to as a debit balance in a margin account. This is the amount of money the broker-dealer has lent to the individual to purchase margin securities. Margin loans are charged interest at a margin rate as determined by the broker-dealer.
  • Equity: This is simply the value of your securities less your outstanding loans or what your account is worth.
  • Maintenance Margin: Think of this as an equivalent of the loan-to-value concept for home mortgages. The maintenance margin states the minimum equity that must be maintained in a margin account relative to the market value of the securities. Regulation T requires a 25% maintenance margin while many broker-dealers require higher levels of maintenance margin. Here is how you determine the maintenance sufficiency:

    If market value multiplied by maintenance margin is greater than or equal to market value less margin loan, then you have sufficient equity.

    If market value multiplied by maintenance margin is less than market value less margin loan, then you will be subject to a margin call.
  • Margin Call: This is a lender-issued requirement that calls on the borrower to deposit more cash or marginable securities in the margin account to satisfy the maintenance margin. If additional assets cannot be deposited, then securities must be sold. To satisfy the margin call under the margin requiremen, the broker-dealer can liquidate securities without prior investor approval. In the GS example, if the value of GS fell below $13,333, then a margin call would be made, since 25% of $13,333 equals $3,333, which is also equal to $13,333 less the initial loan of $10,000.

The Lure of Leverage Returns

What makes trading on margin appealing is the seductive aspect of leverage returns. You can plop down $10,000 to buy $20,000 of stock. When that stock goes up 10% to $22,000 your return on your investment is actually 20% ($2,000 divided by $10,000).

On the other hand, you can get wiped out rather quickly by relying on margin. That $10,000 investment in the $20,000 in stock will evaporate if the stock is down 50%. Luckily, the margin calls will kick in before that occurs to force you to ante up or send you a clear sign to get out.

With margin rates (for example) currently at 8.75% at Morgan Stanley ( MS), you will have to earn in excess of that rate on an annual basis just to make your (pretax basis) interest payments. With the S&P 500 historically growing on average at about the same rate, you have to be very certain that what you are buying on margin will outperform that index.

How to Avoid the Pitfalls of Leverage

There is some middle ground that I think can help the individual investor. Here are four ways in which you can use margin and leveraged investments to your advantage, or how to trade to avoid the pitfalls of over-leverage:

1. Buy stocks in increments. That way when you want to add to an existing position, you do so from cash and not from credit. An even better approach would be to set up an investing budget so you know how much you are willing to allocate to an individual asset class or holding. This requires patience and discipline but will pay off in the long run.

2. Use margin for a quick event-driven trade rather than long-term investment. Say you want to play Google's ( GOOG) earnings for the announcement and conference call. Buy GOOG on margin for the event, but sell it once the news hits the market -- whether you win, lose or draw. Don't turn it into an investment.

3. Margin can be a convenient overdraft protection facility for your portfolio. Say you have a portfolio of $100,000, of which $98,000 is in securities and $2,000 is in cash. There is a stock that you have followed that has hit its entry price point. A round lot of 100 shares would cost you $3,000. Since you are always better off not trading odd lots , buy the stock for $3,000, of which $1,000 is on margin. With only 1% of your portfolio on margin, you really don't have any worries about a margin call or excess leverage risk. Just make sure that your next portfolio transaction is a sell before you buy the next stock.

4. Leveraged ETFs are increasing in popularity, availability and liquidity. The good thing about these ETFs is that they must be bought with cash and cannot be margined. Thus, instead of buying $200 of a regular ETF in a margin account, buy $100 of the leveraged version of the same index ETF in a cash account. Examples of these ETFs are the Ultra S&P 500 ProShares ( SSO), Ultra Dow 30 ProShares ( DDM), Ultra MidCap 400 ProShares ( MVV), Ultra QQQ ProShares and Ultra Russell 2000 ProShares ( UWM).

Some Homework:
  • If you have a margin account, ascertain the level of risk and the interest cost relative to your potential rewards.
  • If you don't have a margin account, consider opening one to use for event trades or trading overdraft protection.
  • Become more familiar with the leveraged ETF products, which can achieve marginlike performance without the worries of margin calls and high interest charges.

You can email me your homework and your thoughts on the subjects covered in this article. I will compile the best ideas in a future module of TheStreet.com University.
At the time of publication, Rothbort was long MER and SDS, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.

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