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How a Margin Squeeze Can Affect Your Investment Portfolio

margin squeezeMargin squeezes become an issue for personal investors after an unexpected decline in the market puts institutional portfolios below their margin requirements. This means that the major portfolios are required to sell off portions of their portfolios (at any price available) in order to shore up their investment accounts with additional cash collateral. Looking at April’s ‘flash crash’ created exactly this sort of situation from rapidly declining commodity prices (including a 10% drop in the price of gold), personal investors should take a moment to understand the timeline surrounding a margin-squeeze, and how it is that this sort of situation both impacts their investment portfolio, and potentially creates a buying opportunity for non-leveraged accounts.

When seeing a sudden drop in stock market values early in the week, investors should take a moment to step back and determine how substantial the risk of a margin squeeze is. This is first accomplished by determining if the decline is pervasive, or subject to a form of ‘snap-back’. For example, if the price of gold declines quickly as a result of low volume, or without any tangible fundamental reason, it is possible that the decline will actually reverse itself just as quickly. However, if the decline is enough to break multiple technical support levels, there is an indication that this drop is material. From there, we need to look at how it is that the decline would impact a leveraged portfolio.

While investment accounts are generally allowed be leveraged no more than 7x their asset value, most personal accounts will not be allowed to exceed 3x for the sake of reason. The trick to making this sort of evaluation is to look at how it is that a moderately leveraged portfolio would need to respond to a decline of similar standings, given the requirements of a standard brokerage account. To do so, we can look at how it is that a portfolio holding $1,000 worth of assets would need to respond to a stock crash if they were using 3x, 4x, 5x, and 6x leverage in their accounts. The chart below summarizes the outcomes for simplicity’s sake:

Margin Requirement to Purchase $1,000 in assets.Portfolio Value that creates a Margin CallAllowed Room for Loss
$300$85015%
$250$90010%
$200$9505%
$166$9990%

 
Looking at this simplified example, we can come to a couple of conclusions about when it is that we should be concerned about a margin call. In the event that a widely held basket of securities should decline by more than 15%, we can be reasonably sure that there will be some form of margin-squeeze placed on leveraged investors. From there, incrementally smaller crashes will create less risk of a squeeze that perpetuates the crash to further lows as investors sell off their positions to cover losses.

In looking at how it is that a margin call can further decrease investment prices, we next need to take a look at the timeline of how it is that such an event takes place. Firstly, investors will often receive a margin call immediately once their accounts breach the requirement margins. From there, they will usually have 3-5 business days to cover out their losses before the brokerage house starts selling off the account-holder’s assets to shore up the account. This means that investors will have the remainder of the week to either deposit additional cash into their accounts, or (more likely) sell off their assets at the best price available in order to reduce the amount of money they have borrowed. The end result is usually a situation where a major sell-off in a widely held asset (such as gold) will actually continue for at least a day afterwards (in reduced magnitude) as investors try to cover out their accounts.

While margin-squeezes are always gruesome to look at from afar, it is important to keep in mind how it is that such events will often create artificially low market prices for specific securities, and therefore create a buying opportunity for investors that have not yet entered into a specific asset class. For example, oil producers declined dramatically as a result of the April flash-crash, only to rebound partially over the course of the week to better reflect their tangible value. The end result was that investors were presented with an opportunity to buy in on these companies at better prices as a result of the short-fallings of leveraged investor’s strategies.

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