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What They Are – How They Work

By William H. Mears; CPA, JD

Margin is defined as the capacity to purchase securities with a loan against an existing position.

A Method of Leverage

Using margin, a physician-investor can increase exposure to potential gains and increase returns.

Conversely, by leveraging current investments, a physician investor can increase exposure to market risk.

Where an investor can reinvest margin proceeds and earn a return in excess of the borrowing cost, the investor has increased total return.

Assessment

However, if a physician investor borrows against a position to invest in securities that decline in value, that investor’s loss is in effect doubled (if the investor had margin up to the legal 50% limit).

Example:

Dr. Prince Price, a dentist who has a $1 million portfolio of low-cost basis securities, would like to invest in a new initial public offering (IPO). He feels certain that the stock of this new initial public offering company will skyrocket.

Prince asks his wife if he can take a home equity line of credit against their house to purchase the stock, but his wife, a financial planner, advises against this strategy. She recommends that Prince take a margin loan against his stock portfolio if he really must invest in the IPO. The margin limit on his account is $500,000, or 50% of the current market value of the portfolio.

Prince decides to invest $500,000 in the new IPO. He purchases 50,000 shares of the $10 stock on the offering.

The new stock closes the first day at $20. In 90 days, the stock is worth $50 a share. Prince sells his stock for $50 a share, taking a short-term capital gain of $40 a share. His financing cost on the margin loan, the 7% for 90 days on a loan principal of $500,000, is his opportunity cost and reduces his net economic gain.

Assessment

At the end of the transaction, Prince calculated his net profit as follows:

Gross proceeds:  $2,500,000

Cost basis:            $500,000

Cost of capital:          $8,749

Net profit:            $1,991,251

Conclusion

What has been your personal experience using, or recommending, margin accounts; please comment?

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