The Risks of Margin Trading Proven by Actual Examples
The risk that directors of listed companies offer to regular shareholders through their massive margin trading of shares has been highlighted by a number of high-profile share price falls on the Australian Stock Exchange in recent times. The ramifications have been so substantial that no stock market trader can afford to disregard the lessons.
Listed companies often look favourably upon directors with large shareholdings because it shows that their interests align with those of executives and other private shareholders. However, this ideal can be severely undermined when directors' large shareholdings are accumulated through and continue to be used as collateral for margin loans. While directors who take on debt to fund their investments run the risk of exposing themselves to manageable levels of risk, other shareholders face a far larger, more subtle, and sometimes unanticipated threat as a result of these same directors' actions.
The fallout from being exposed to a declining market can be catastrophic for everyone involved.
To put it simply, margin trading is taking out a loan from a brokerage to buy stocks on deposit, with the shares themselves serving as collateral. There is an increased chance of both gains and losses when trading shares on margin, as is the case with any leveraged trade.
Due to the director's perceived influence on the company and the scale of business that such a purchase will bring to the margin broker, a private investor may be able to borrow up to 50% of the collateral value, subject to other margin account criteria such as maintaining a minimum balance. Therefore, the director's margin is a meager twenty percent of the one million shares purchased through a margin broker, which cost ten dollars apiece. The $8 million in borrowings and the $2 million in "equity" put up by the director bring the total acquisition price to $10 million. The director's holding of 1 million shares will be reduced to $9 million, but they will still have to pay $8 million in debt (breaking the 80 loss) and will be served with a "margin call" for an additional $1 million to bring the loan/asset ratio back to what it was originally. If the call is not met, conditions will be invoked. Permitting the margin broker to sell a portion of the holding in order to re-establish the necessary 80% in the $10 share price to $8 would result in the complete eradication of the director's initial $2 million equity. Furthermore, if no margin call is met, the broker will likely sell the entire holding at the best price to minimize losses. The share price of the company would likely plummet despite the fact that it might still be a viable enterprise due to the combination of volume pressure and the accompanying publicity from stock exchange disclosure obligations. The director would still be held liable if the broker was unable to recover all of the funds through the sale of the collateralized shares.
Unaware of the dangers lurking around them, private stockholders find themselves caught in this predicament.
In no way is this an academic situation. In some prominent Australian cases, the dumping of related party shares led to a precipitous decline in share prices, suspension of stock exchange listings, the dismissal of directors and executives, and the erasure of their entire shareholdings in the firm. Some cases may involve substantial residual personal responsibilities. The result has been a huge decline in the value of private investors' assets as well.
Any business that meets this fate will, needless to say, have a very hard time getting new equity funding and will have to pay a premium for debt, especially in this credit-crunch era. If the business can maintain its financial stability, then liquidating assets quickly becomes the best option for funding a reorganization.
Even if they don't lose their jobs, private investors who engage in margin trading with the same company could end up in a same situation as the directors.
You can access a more comprehensive case study by clicking on the resource link.
According to the case study, even secured investors in connected companies can be severely hit by the far-reaching and disastrous consequences of a big margin call default.
How can a private investor prevent this undesirable consequence from ruining what appears to be a decent investment?
As we've already shown, it's not always easy to spot directors' and executives' potentially harmful margin trading. However, stock exchange announcements might provide some hints. Even better, you may just inquire with the Company Chairman in a private letter or during the Annual General Meeting of Shareholders. Businesses who can say they have no involvement in these types of operations will likely be pleased to do so. Look into the rest.
Not only did directors in one recent case buy shares on margin for personal use, but they also used shareholder cash to buy and sell other listed shares. It goes without saying that after a slight reversal in the markets, the company and its shareholders quickly lost millions of dollars.
Good advice for private investors is to stay away from margin brokers completely. Having said that, there are still situations in which the leveraged acquisition of shares makes sense as an investing strategy. However, it does establish an essential distinction among shareholders, sharebrokers, and financiers.
A large bank allegedly sold off the whole share portfolios of several private investors in one recent margin trading instance in Australia in order to pay off the investors. The investors' nominees had their shares held by the bank. Investors on the margin were left high and dry as unsecured creditors when the margin brokerage business went under. Getting out of this jam would be an incredibly tall order.
Investors should be aware that new chances for extraordinary profit also carry extraordinary new risks, especially when more intricate methods of trading traditional share markets like options, short selling, stock borrowing, and margin trading are being developed. A few may be avoiding accountability by claiming "immateriality" even if their actions could have catastrophic results.
To sum up, individual investors can lessen their chances of losing money on margin trades by following these steps:
Exercise caution while dealing with rapidly expanding businesses. The large profits promised by significant margin trading tend to entice these corporations and their prominent directors the most, since they ignore the extraordinary dangers that others and themselves face as a result. Find out if directors, executives, and associated parties engaged in margin trading by reviewing public statements and news from the stock market. Even though they're not easy to spot or decipher, these do exist. Just check with the company's chairman to see whether any of the directors or executives are involved in margin trading the company's shares. whether they are, it's best to avoid them. Another potential red flag is if the corporation is using shareholder money to margin trade the shares of another company. Do not use your personal margin share trading accounts to buy shares; instead, borrow money elsewhere. If you buy shares on leverage, make sure they're registered in your name. If your sharebroker goes bankrupt, a higher-ranking creditor could try to seize them.
Until stock exchange listing regulations make it essential for firm directors, executives, and associated parties to disclose their margin trading, equity investors will have to consider "margin trading risk" while making their own decisions.
