Understanding Margin Trading

Understanding Margin Investing

Almost all stock brokerage firms offer margin trading, which is essentially borrowing money from them to purchase more stocks. Many investors do not understand margin trading or whether or not it is good for them.

Deciding whether or not to borrow on margin is a business decision like any other. When you borrow on margin, you are borrowing money to buy stocks, using the stocks you currently own as collateral. If you think the stocks you will buy will significantly outperform the margin rate you pay, then borrowing on margin may be good for you.

Why Use Margin When Trading?

For example, let’s say you have a very large asset base, let’s call it $10 million. You believe the market is incredibly oversold, as it was a couple weeks ago. You want to borrow money to invest in the market. Deciding to borrow $2 million, paying 5% interest. You believe that you can make 15-25% on the money you borrow, well above the interest rate you are paying. In this case, borrowing the money on margin looks like it will make a good payoff.

As you can see, the three key factors here are the margin rate you are paying, the amount you can make off of the money you borrow, and your risk tolerance. The above example, however, is a very optimistic one. Most of the time, for people with average or small asset base, margin rates are very high, generally 8.5% or more and can easily be 10% or more. Furthermore, the market returns about 10% a year on average, so most of the time, borrowing on margin mean taking on a lot of risk for potentially very little reward.

Margin Trading Risks

What exactly are the margin risks? Well, besides the fact that you are betting more money, so you can lose more money, you also risk a margin call. Let’s say you have $50k and borrow $50k on margin. The market gets pummeled, and your $100k in total investments ($50k yourself plus $50k you borrowed) drop down to $70k. At this point, there’s a very good chance you’ll receive a margin call. The broker will demand that you sell securities (or put up additional funds) so that you reach a certain level. For example, the federal government requires brokers to have at least a 25% maintenance requirement, though most brokers have a higher number.

Let’s say your broker has a 30% maintenance requirement. Since you borrowed 50k on margin, you will need to maintain an overall balance of about $71k or more before receiving a margin call. If you get a margin call, you will need to put up more money from your bank account or start selling securities.

Let’s say, in the $50k +$50k example that you’re somehow forced to sell all of your securities after your balance dropped to $50k. Now, all you have is $20k minus what you paid in margin interest. Even though the market only dropped down by about 30%, you ended up losing over 60% of your funds since you leveraged yourself.

As you can see, margin trading involves a lot of risk. It should only be done by expert investors who know what they are doing and can get access to a decent margin rate. For average investors, margin trading is generally a bad idea.

Financial Success Even Without Making a Lot of Money

Achieve Financial Success Even Without Making a Lot of Money

For a variety reasons ranging from talent, education, luck, parentage, health, individual capacity, timing and opportunity, people have different levels of money making potential.  This concept, something we all see as part of day-to-day life, is illustrated in “The Parable of the Knights’ Contest.”  With that in mind, let’s now take a closer look at the parable as a means to better understand the reasons behind people’s differing levels of income potential and what that means to you in terms of your own prospects for you to achieve financial success.

The Strong Knight: Opportunity Combined With Hard Work & Persistence

First consider the strong knight.  He was someone who was born with a capacity for great strength, but that was just the beginning.  From a young age he built on his physical advantages, and through discipline, personal sacrifice and many hours of training and hard work, he became the most physically powerful knight in the entire kingdom.

The strong knight can be compared to someone who makes a lot of money because they worked hard to take advantage of their opportunities.  For example, the strong knight would be representative of a young man or woman that started out in life with the advantage of a good mind and affluent parents who were actively involved in their education.  But things didn’t stop there; as the young man or woman grew up they seized on the advantages that they had, and through their efforts they were eventually accepted to a prestigious university, earned an advanced degree and secured a high paying job.  Thus, financially speaking, they developed into a strong knight.

The Swift Knight: God-given Talent and Unearned Privileges

Now consider the swift knight.  He was born with the God-given gift of exceptional speed.  And while he had avoided obvious unwise choices in life that would have endangered his special talent (such as taking foolish risks or abusing his body with drugs and alcohol), he had been lucky as well (e.g. he hadn’t suffered a serious injury).  It’s also significant that this particular knight hadn’t worked terribly hard to become fastest knight in the kingdom.  While it’s true that he did the standard workouts that all knights must do, he really did nothing beyond that.  Yet despite the fact that he only put forth an average amount of effort, neither the strong knight nor the average knight could come anywhere close to matching the swift knight’s breathtaking speed.  The simple fact was that he had a gift; he knew it, and everyone else knew it, and that’s the way it was.

The swift knight can be compared to someone who has an advantage that’s practically impossible to replicate through study, hard work, or anything else.  Consider artistic talent.  You could decide to drop everything and dedicate the rest of your life to painting, yet there would always be someone who was so talented that with minimal practice, training and effort, they could still paint better than you.  That’s just the way it is – some people have simply “got it.”

Artistic ability has to do with talent.  As far as financial matters are concerned there is an even better example of a “swift knight.”  To illustrate, consider someone who was born very average in terms of intelligence, height, weight, looks, etc.  That would mean that their financial outlook would be…average, right?  But what if I also told you that this person’s parents were mega wealthy and that they stood to inherit $100,000,000 when they came of age?  Suddenly, with no effort their part, this “average person” would instantly have access to more money than most highly skilled professionals could accumulate by working hard their entire lives.  Is that fair?  Whether it is or not doesn’t matter because, in certain cases, that’s just the way it is.

Reach Financial Success As An “Average Knight” Through Effective Money Management

And what about you?  What if you’re just an “average knight” (or a “regular person”) in terms of your money making potential?  Are you doomed to failure and mediocrity?  Absolutely not!  As the parable illustrates, the race doesn’t always go to the swift or the strong.  What set the average knight apart wasn’t his ability to pour water at an unusually high rate, but the fact that not a singe drop of it was wasted.  In other words, the average knight can be compared to someone who might only make a modest amount of money, yet they manage the money that they do have extremely well, putting every bit of it to good use.

In conclusion, I want to make it clear that I’m not discounting the importance of making money.  Making money is an essential part of achieving financial security, so make as much money as you reasonably can in an honest, balanced way.  But what I also want you to impress upon you is the principle illustrated in the parable, that there is a lot more to achieving financial security than just making money.  It also takes savvy and effective money management, which involves knowledge and planning followed by steady, consistent, and thoughtfully applied effort. Achieve financial success by managing your money effectively – that is where you get your edge, that is how you win the prize, and that is what this website is all about!

Financial Life

Financial Life or Death – Being Honest With Yourself

A Financial Life Truth Test

Take some time to consider two important questions about your financial life.

  • What do you say to other people (your spouse, kids, co-workers, friends, parents, etc.) in terms of how money should be managed?
  • What financial priorities do you think and feel are important?

Here are some possible responses you may have come up with in terms of what you say and how you think and feel about money management.

  • It’s important to live within (or even beneath) your means.
  • It’s important to save for retirement.
  • Credit card debt should be avoided at all costs.
  • It’s important to have some money set aside for emergencies and other unforeseen expenses.
  • I think it’s important to give to worthy causes, and to those who are less fortunate.
  • Christmas (and other holidays) have gotten over-commercialized.
  • I’m my own person; I don’t pay attention to what others think about me.

You could have come up with other responses as well, but you get the idea.  Now consider an even more important question.  How do you actually manage your money?  In other words, is the way you spend and manage your money in alignment with what you say and feel is important to you financially?  In thinking about that, consider the following.

  • Do you live in such a way that you’re able to make ends meet from paycheck to paycheck without turning to your savings or credit cards to make up the difference?
  • Do you already have enough saved for retirement?  If not, is your present level of savings sufficient to meet your goals?
  • Are you presently carrying a balance on your credit card from month to month?  If so, are you taking steps to eliminate any credit card debt that you may have?  Are your credit card balances increasing, decreasing or staying the same?
  • Do you have enough money set aside in savings to take care of an expensive car repair, home repair, or other unforeseen expense?
  • How much of your money (and/or your time) do you currently give to your community, church, charitable organizations or other worthwhile causes?
  • Do you go overboard in your purchases for Christmas, Halloween, or other holidays?  Do you go into debt to do so?
  • Do you avoid factoring in what other people may think about you – whether you want to be perceived as successful, sophisticated, cool, etc. – in terms of choosing where you live, the car you drive, the clothes you wear and the personal items that you buy?

Now, are you comfortable with the way you answered the questions above relative to what you said and how you feel about managing money?  If so then you can almost be assured that you’re being honest with yourself financially.  On the other hand, what if you have every intention of being financially responsible, yet in going through this exercise you realize the way you’re managing your money isn’t matching up to what you say and feel is important to you?  If that’s the case then it’s important to recognize that in order to align your actions with your values you’re going to have to make some changes – real, fundamental changes – some of which may be very difficult.

Dangerous Money Management Mentalities:

Exceptionalism and Procrastination

If you’re struggling with the idea of making difficult changes then you can opt for some ever-tempting alternatives.  The first is that you can attempt to feel good about yourself simply by justifying your present course action.  The speech goes something like this: “There are exceptions in my case.  Although I spend all of my excess money on [the latest electronics, fashionable clothes, expensive cars, high-end vacations, serious hobbies, and other things for myself], what’s really important to me is [family stability, having enough set aside for emergencies, giving back to the community, saving for retirement etc.].”

An alternative line of thinking might be even more dangerous and seductive: financial procrastination.  In your mind it would sound something like this, “Once I have [done this] or [have that] THEN I will [start paying off my credit cards, saving, etc.].  And why is financial procrastination so dangerous?  It’s essentially because it enables you to (seemingly) have your cake and eat it too.  In other words, a deeply embedded financial procrastination mentality enables you to spend your money irresponsibly today because you’ve convinced yourself that you’re going to start managing it responsibly tomorrow.

Having said all of this, it ultimately falls to you to be your own judge.  After all, perhaps you really are one of those rare exceptions; maybe you really are at a time in your life where your education, career or a personal goal you’re pursuing is temporarily throwing things out of balance from a financial point of view.  Or maybe after you have gotten certain things you really will turn the corner in terms of your financial discipline.  But just remember, in the end it’s your actions over a sustained period of time – not what you say, think or feel – that are the truest reflection of who you are and what’s really important to you.

Where Do You Go From Here?

So where do you go from here?  First, if you’re already living your financial values then don’t get complacent; keep at it!  On the other hand, if you’re not then take heart.  The very fact you’re reading this article is an indication that you’re serious about getting your financial house is in order.  But if you’re really going to right your financial ship you have to take things further: you have to actually be willing to admit to yourself that your money-related actions are out of alignment with your values.  If you can do that – if you can cultivate that kind of self-awareness – then you’re being honest with yourself.  And if that’s the case it’s an extremely encouraging sign, because if you’re willing to acknowledge there’s a problem then you can start to take constructive steps to deal with it.  On the other hand, if you choose to not be honest with yourself by ignoring financial realities right in front of you then I don’t think you will ever truly be able to get a handle on your finances (or any other worthwhile aspect of your life for that matter!).  And what does that mean?  It means that being honest with yourself is a matter of financial life or death!

Financial Principles Parable of the Knights Contest

The Parable of the Knights’ Contest

The Rules of The Game

Once upon a time a busy king decided that he needed to appoint a chief counselor to help him manage the affairs of the kingdom.  So one day he announced a contest between three of his knights to determine who would get the job.  The task would be to see who could fill a barrel with water the fastest with the entire kingdom looking on.

The day before the contest the king gave each knight the item they were required to use to fill their barrel.  To the strongest knight of the kingdom he gave a large bucket.  To the swiftest knight he gave a pitcher.  And to the last knight – a regular knight nobody thought of as having any special abilities – he gave an ordinary drinking mug.  The knights were then given identical materials to build their barrels and were then commanded to have them ready for the contest on the morrow.

Discouragement…and hope

When the regular knight had first read the scroll from the king’s messenger that he had been selected to be in the contest he was nervous, and when he learned who his opponents would be his nervousness turned to anxiety.  But when he learned the rules – that he would only have an ordinary drinking mug to fill his barrel – he was utterly distraught as he considered the nearly impossible (not to mention humiliating) situation he faced.  He couldn’t relax, he couldn’t eat, and he couldn’t even concentrate on getting ready for the contest.  It seemed like the only thing the regular knight’s mind could focus on was the sickening feeling of stress he felt in his stomach at the thought of the upcoming competition.  Finally, tired of feeling in disarray, he stepped out of his cottage to take a walk in an attempt to clear his mind.

A short time later it just so happened that the regular knight encountered a wise old merchant he knew who had run a successful mill by the river for many years.  Desperate to talk to someone who might be able to help, the regular knight told his friend about his problem.  The wise old man carefully considered the regular knight’s plight, and after a great deal of thought he finally said, “There is simply no way that you can compete with the strength or speed of the other two knights” (the regular knight slowly nodded and looked dejectedly down at his feet).

But the wise old man paused as he thought a bit more and then added, “But the contest isn’t about your individual strength or speed, it’s about filling a barrel with water as quickly as possible” (the regular knight now looked up hopefully and began to pay closer attention).  Then he continued, “In all my years at the mill I probably saw a million barrels, so I can tell you from experience that few people in our kingdom know how to make a good one.  It’s not an easy thing to do, especially with as little time as you have.  But what if I taught you the techniques necessary to make the perfect barrel, one that wouldn’t leak at all?  That way, even though you wouldn’t be able to pour water at the same rate as the other knights, you might still have a chance to win the contest, because your barrel would retain all of its water while theirs might leak quite a bit if they don’t prepare as carefully as you do.”

The regular knight was stunned by the old man’s simple yet profound advice, and after turning it over in his mind for awhile he quietly said, “You know, I think that can work.”  And with that realization the regular knight felt a tremendous surge of motivation, strength and energy because, for the first time, he truly felt that he had a chance to win the contest.  And it was all because he had a plan, a plan that he really believed could give him a shot at victory.  Now, instead of dreading the contest and just wanting it to be over, the regular knight was anxious to get to work.  He rushed back to his cottage and immediately began constructing his barrel, carefully following the instructions of his wise friend.  It took much longer than he thought it would, and he had to start over a few times, but by working all through the night he was able to finish the barrel with just enough time to make it to town the next morning for the contest.

The regular knight arrived at the arena without a minute to spare.  He had been working so hard that he hadn’t thought much about the event itself, so at first he was a bit overwhelmed by what he saw.  Practically the entire kingdom was on hand, and across the way were his huge and fast opponents.  Silence fell upon the crowd as they looked upon the regular knight.  There he stood disheveled, unwashed, unshaven, and clearly wearing the same (now wrinkled) clothes that he had on the day before.  As the regular knight made his way to the starting area, mug and barrel in hand, the whispering began, and he felt as if every eye was upon him and that they were all asking the same question, “What is he doing in the contest, anyway?”

Suddenly the regular knight felt completely out of his depth, and he was sorely tempted to ask himself the same question.  But at that critical moment he looked down and saw the perfect barrel in his hand.  Then he remembered all of the work, planning and sacrifice that it represented.  Thinking about that filled him with a quiet confidence and he calmly took his place at the starting line, looked straight ahead and said to himself, “I’ve prepared for this moment…I’m ready.”  And with that the contest began.

The Contest Unfolds

At first the contest went as expected.  The strong knight wasn’t that fast making his way back and forth across the arena between the water source and his barrel, but he was able to draw large amounts with his bucket and pour water into his barrel at a measured pace.  Armed with his pitcher, the swift knight couldn’t pour as much water into his barrel per trip as the strong knight but, due to his great speed and seemingly endless endurance, water seemed to be going into his barrel at just as fast a rate.  As a result, a tense excitement gripped the crowd, because it looked as if the contest was going to go down to the wire.

As all this was happening the regular knight methodically made his way back and forth between the water source and his barrel.  Some briefly paid attention to him long enough to feel sorry for him.  Surely he had to be a bit embarrassed down there running around with his pathetic little mug with no chance of winning.  Others singled him out, laughing and jeering at him, secretly glad that they weren’t called upon by the king to endure such public humiliation.  But for the most part people simply ignored the regular knight.  After all, he wasn’t going to be a factor in the contest; everyone supposed he was just there to round out the field.

Then, as the contest wore on, something happened.  The water in the regular knight’s barrel got high enough that it caught glints of the morning sun, drawing the attention of the crowd.  But what truly shocked them was what they didn’t see: there weren’t similar signs of progress in the barrels of the other two knights.  Everyone wondered how this could be.  Was it the angle of the sun playing tricks on their eyes?  Then it dawned on the crowd what had been happening: the other knights’ barrels had been leaking water all along, something that hadn’t been obvious before because the ground around the barrels had gotten so wet due to the spilling that had been occurring during the course of the contest.

A spontaneous cry suddenly broke through the shocked silence that had fallen on the crowd, “Let’s go regular knight!”  That caused a bit of a stir among the spectators; they weren’t quite sure of what to make of the scene they were witnessing.  Then someone else yelled, “You can do it!  Do it for the regular people!”  At that the crowd began to buzz with excitement, and more began to cheer on the regular knight.  It seemed as if he had magically transformed before their eyes, because now when they looked upon him they no longer saw a regular knight; they saw the people’s knight, their knight.  And so the cheers of the crowd grew louder, and louder and louder…

The regular knight had been concentrating so much on the contest that he hadn’t been paying much attention to the crowd.  Fill the mug…pour…run for water.  Fill the mug…pour…run for water.  Yet in the midst of his efforts he noticed that the arena had grown strangely quiet, and then he even thought he heard a few people cheering him on.  After that, however, all he could tell was that the crowd had gotten unmistakably louder and more animated.  Clearly, he thought, one of the knights must be getting close to winning the contest.

A Run For the Money

Now curious, on his next trip to pour water into his barrel the regular knight paused a moment to see how things were going.  To his astonishment he saw that his own barrel had filled up quite a bit.  He quickly looked at the barrels of his competitors and saw that they weren’t making similar progress.  Then it hit him: he was the one that was winning!  Suddenly he no longer felt any fatigue from either the contest or his lack of sleep from the previous night, and with a jolt of excitement he took off to get more water.

The strong and the swift knights had also noticed the activity in the crowd and they, too, took a look in their barrels, each certain that they were the ones on the cusp of victory.  But after doing so they were stunned, and it was now their turn to feel a sense of panic.  Despite all of their efforts there was hardly any water in their barrels at all, but the regular knight’s was filling up!  After hurried inspections they realized that their barrels were leaking badly, and so they frantically tried to replicate in a few moments the kind of workmanship it took the regular knight all night to produce.  However, the strong and the swift knight soon realized that with no tools, no time and the pressure of the contest upon them, it was impossible to do anything to their barrels at this point that would have a meaningful effect.  As a result, they felt the only course of action left to them was to try and pour water into their barrels at an even faster rate.

With that singular thought in their minds the strong and the swift knights, in a final desperate attempt to seize victory, reached down into their deepest reserves and began to compete with an almost maniacal fury.  The strong knight had never exhibited such raw power; the swift knight had never run with such breathtaking speed.  For a moment, despite the burst of energy he had received from catching a glimpse of victory, the regular knight was almost overcome by the awesome display put on by his rivals.  But, inspired by the knowledge that his plan was working, he bore down and relentlessly continued on.

Things went on like this for a time when finally, with the entire kingdom looking on, water flowed over the top and then down the sides of the regular knight’s barrel and in a slow, almost surreal fashion.  The contest was over.  The crowd, which had already become extremely loud by this point, let out a deafening roar.  The regular knight, who everyone had previously considered to be average at best, had pulled off the most stunning upset anyone had ever witnessed, a victory for the ages.  And so the crowd celebrated, but it wasn’t just for the regular knight that they cheered.  It was also for the idea he represented, that everyone who had ever been thought of as “regular person” had the potential to accomplish great things in the face of overwhelming odds.