Buying on Margin
Buying on margin is the practice of buying stock with borrowed money from a brokerage firm. When you buy a stock on margin, you expect the stock to increase in price so you can sell the stock at a profit, pay off the margin loan and pocket your profit. While you are waiting to sell the stock, you pay interest and fees to the brokerage firm. Also, you have to have a specified per cent of the borrowed amount in your account in the form of cash or other securities to act as insurance if the stock price declines.
Buying on margin lets you buy more stock than you can immediately pay
for. As long as the stock moves up in price, you successfully leverage
your account and make money. But what happens if the stock goes down in
price after you bought it on margin? If it declines enough, your broker
is legally obligated to make a margin call, which means you have to come
up with additional money to cover your margin requirements. In this scenario
you have no right to object or argue. You must meet the margin call and
you must do it in the prescribed time frame (usually immediately) as described
in the margin agreement.
The worst-case-scenario is when the margined stock falls in price very quickly. The broker may sell other securities in your account without contacting you. And if these sales didn't bring in enough to meet the margin call, you would have to come up with more the money. You might have to drain cash from other accounts or sell other assets or mortgage your house. You are legally bound to meet the margin requirements.
Using Margin to Exercise-and-Hold
Some corporations give employees stock options as a form of compensation. Usually the options have conditions such as the price you pay for the option, which is usually well below the current market value, time restrictions specifying when you can exercise the options, and the number of options you can exercise at different dates.
When you exercise the options, you may buy the options at the exercise
price and then immediately sell the options at the current market value.
But, you must pay for the shares at the exercise price before you can
The profit per share is the difference between the market price and the exercise price. For example, if the market value is $100 and the exercise price is $10, the profit per share is $90. When you exercise and immediately sell your options, you pay tax on the profit as ordinary income, which is the highest tax rate you can pay.
To avoid paying this tax rate some people use the exercise-and-hold strategy. Here, you buy the stock at the exercise price and hold the stock for one year and a day or longer before you sell it. Therefore, your profit is taxed as capital gains, which is a lower tax rate than the rate for ordinary income. When you exercise-and-hold, you hope the stock retains its value or rises in price during the holding period.
Often, employees with many options must borrow money to purchase their shares. If they borrow money from the broker to buy the shares, they must establish a margin account. They pay interest and fees and must meet margin requirements if the price of the stock falls a certain amount, which is spelled out in the margin agreement
If all works out as planned, the stock goes up or stays flat during the holding period. You sell the stock after the holding period, make a handsome profit, pay off your margin loan and pay tax at the capital gains rate.
But if the stock price collapse during the holding period, your broker must ask for margin calls, which compel you to add new money to your margin account to cover the loss in value of your stock. If the stock collapses below the exercise price, the stock is worthless but you still owe the margin debt.
The following story of financial disaster is taken from "Out of Options", an article from Forbes magazine. Kelly Kearney decided to retire from WorldCom and was told she had to exercise her stock options or lose them.
The following excerpt from the article summarizes her troubles. "Kearney exercised 28,600 options and soon had $1.3 million in WorldCom stock sitting atop a $600,000 margin loan from Solomon......WorldCom's stock tanked in the summer of 2000......As Kearney receive over a dozen margin calls, she struggled to raise cash, draining $58,000 from other accounts and borrowing $195,000 against two homes. By October 2000 it was all gone."
In effect, she had to pay back the $600,000 loan plus interest and fees even though the value of the WorldCom stock was much less than what she owed.