Diana Clement: Money to be made at the margins

If you've caught the sharemarket bug, then what can be better than something that amplifies your gains? Step forward margin trading.

At its most basic level, margin trading is fairly straightforward. It's about borrowing money to buy shares and other securities such as warrants or contracts for difference (CFDs).

Quite simply, you borrow money, buy more securities than you could otherwise afford and, when (if) the price of the security has risen, you repay the loan and take the profits.

It's much the same as buying an investment property. Few people have sufficient cash to buy the house outright. Therefore, you take out a mortgage to buy the property.

If it goes up in value, any capital gain over and above your equity and the outstanding mortgage is yours.

With margin trading, your profits, assuming the security goes up in value, will be amplified. If you'd bought $1000 of a stock outright and it rose by 10 per cent you'd make $100 profit. If, instead, you'd borrowed more money to buy $5000 of that security and it then rose in value by 10 per cent, you'd make $500. It should be said that this equation ignores brokerage, stock exchange fees and interest on your loan.

With margin trading, the lender holds the shares as colla-teral, but you still get the dividends. What's more, you can write off the cost of the loan against the dividends for tax purposes.

The big difference between margin loans and investment property is that, in a bad market, your house won't disappear. Even if it burns down and you're uninsured, you'll still own the land, whereas investors have seen share investments go down the pan. Just remember the 1987 sharemarket crash. One day here, the next day gone. You could, in theory, be left holding the loan with no shares to show for it.

NZX products group manager Geoff Brown points out that lenders monitor trades and the lender would make a "margin call" if the security fell in value too much, requiring you to top up your deposit to a minimum level

Nonetheless, borrowing money to buy shares (or "gearing") can also amplify losses. It's the exact opposite of the example above, except you'd end up owing $500 instead of $100 if the value of the shares fell 10 per cent.

Although little is written about margin trading, many sharebrokers such as ASB Securities and ABN Amro Craigs offer margin loans to clients, says Brown. Some, but not all, of the services available in New Zealand use Leveraged Equities Finance, a subsidiary of stockbroker Forsyth Barr, to provide the loans.

Typically, Leveraged Equities clients borrow at between 2.6 per cent above the 30-day bank bill rate [7.45 per cent last week] and 5 per cent above, says manager Alan Nixon.

He says margin lending has grown significantly here in recent years - despite little industry marketing. Far fewer Kiwis per capita trade on margin - in part because we've taken longer to recover from the 1987 shock.

CFDs

Contracts for difference or CFDs - a relatively new concept in the market - can also be traded on margin. A CFD allows you to make a profit or loss from fluctuations in the price of an underlying share or index without owning that security.

Companies such as CMC Markets and OM Financial offer CFD and foreign exchange trading on margin to sophisticated investors. With CFDs, you can make money in a rising or falling market; you can sell a CFD that you don't own and profit if the security falls. While trading CFDs on margin is viewed as being more risky than buying equities on margin, many traders use "stop-losses" that set a pre-determined price at the beginning of the trade, which will automatically trigger a sale - limiting your losses.

In the book Real Traders, Real Lives, Real Money, by Eva Diaz, CFD and foreign exchange trader Anita Eliezer says she prefers the bigger position that can be held with CFDs over shares. "I can open up $10,000 worth of trade with only about $300 if a share CFD has a 3 per cent margin. This means that I can either open more positions or bigger trades than I can open if I have to trade shares."

Another book, Making Money in CFD Trading, would also be a worthwhile read for anyone contemplating dabbling in this market.

Risk seen as less than borrowing to buy a house

Steven Anderson has been investing in shares since he was 18 and began investing on margin as an individual while he was here setting up the New Zealand arm of financial services company Cannex.

Anderson has a $100,000 limit of borrowing via two facilities - a margin loan from his bank and also a small line of credit on his house which he uses to buy shares and warrants on margin.

While novice investors may find Anderson's style of investing hair-raising, he sees the risks as relatively small. Typically, about 40 per cent of his investments are on borrowed money - although he has the potential to be geared up to 75 per cent.

"Personally, I think it is far more risky to borrow up to 90 per cent of a house as an investment," he says. Hot water services blow up, doors break, gutters need replacing. "The chances of a margin call [the lender asking for its money back] on 40 per cent gearing is minuscule." Anderson says his annual compound return over the past 16 years has been 20 per cent per annum.

Unlike property investment, there are few courses and seminars dedicated to margin trading. So educating yourself may be a DIY affair. You can buy books on the subject. The website Sharechat.co.nz has a section on CFD trading and CMC Markets is giving away free CD-Rom-based courses as an introductory offer. You can find free online courses from websites by checking out Worldwidelearn.com.