Leverage is best thought of as a kind of non-riskless liquidity that depends on credit availability. Not enough credit, bets are limited; too much credit, bets can quickly turn against one.
The solution to this for most retail investors is simply not to invest on margin and stay fully invested according to their own personal finance goals. For institutional investors and indeed for many high-net-worth individuals, staying away from credit is too inefficient to be practicable.
A simple example can demonstrate this. Imagine you have a $10 million account 100% in equities at all times. The market falls 30%, so your account is now $7 million, and you want to buy more because you have a long-term view. Without credit, you won’t be able to double down on that position even if you want to. However, if you’re certain that the current market is experiencing short-term volatility and the long-term trajectory of your investment is up, there’s nothing you can do without credit.
To ensure credit in investing isn’t abused, the SEC has guidelines that stem from the large acts of the 1930s, and it is incredible that a system designed nearly a century ago is still extremely functional and has limited financial panics so that they are less frequent and severe than in the past.
The structure of margin account regulations is particularly clever in that it allows for the extension of credit and a market-driven mechanism to ensure leverage doesn’t go too high. Let me explain what I mean. The rules begin with Regulation T, which says that an investment requires a 50% initial margin (that ratio is set by the Federal Reserve and can change), while a long account using margin will need to ensure that it maintains a 25% debt ratio.
Simple enough rules but calculating them in practice is a bit complicated. The formula to calculate this is Debt / (1-.25) or D/0.75. Thus, an account that owes 25k will need to have $33,333 in value at a minimum to avoid a margin call.
In practice, this is a bit more complicated, so let’s walk through the steps.
- A margin account is established (this requires its own bits of rules and regulations, but fortunately these are straightforward and well defined by FINRA)
- The account must have half of the assets it purchases funded in cash to satisfy the 50% initial margin requirement. So, a $50,000 purchase can be bought with $25,000.
- That account will have a long market value (LMV) of $50,000 and a debt value of $25,000, resulting in equity of $25,000.
- This results in the formula LMV – D = E (50,000 – 25,000 = 25,000), which is important for future calculations since the D level will not change unless stocks are sold or money is added to the account.
- If the LMV falls to $33,333 (D/.75, or 25,000 / 0.75), the account faces a margin call.
- The stock bought on margin at 50% can fall 33% before facing a margin call.
If you’re studying for the Series 7, you’ll need to study this and SMV formulas and how to calculate them if LMV, SMV, D, or E is missing. If you’re working in the industry, however, you’ll probably use a table like this as a rough guide:
| Initial Margin | Margin Call Decline |
| 50% | 33.3% |
| 40% | 46.7% |
| 30% | 60.0% |
| 20% | 73.3% |
| 10% | 86.7% |
This quick table shows how much a position can decline before facing a margin call, with the amount of initial margin inversely proportional to how much of a decline a portfolio can handle.
This gets especially exciting when we start to compare it to different asset classes and their max drawdowns in history. In theory, an asset whose CAGR exceeds borrowing costs and whose largest historical drawdown is lower than the max margin call decline could, in theory, use aggressive leveraging to boost returns. For instance, stocks’ largest drawdown in the Great Depression was 83.4%, so a 10% leverage position would not have faced a margin call even during the 1929 crash and subsequent multi-year bear market.
Further divisions of assets according to risk and reward can drill down these historical trends for smaller pockets of markets where the risk/reward profile might lend itself to leverage, illuminating ways to use credit to boost returns.
Those divisions make and break careers. The best at leveraging investments become billionaires; the worst either get fired or go broke messing up with their retirement accounts. The financial industry, however, is filled with a lot of people in the middle, who have found a good match of credit, risk, opportunity, and cost to improve returns in accordance with the regulations and limits of our capital markets.