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Bear Markets and Margin Calls — What to Do?!

Posted May 16, 2022

Zach Scheidt

By Zach Scheidt

Bear Markets and Margin Calls — What to Do?!

"Could you share some suggestions for people who are stuck with margin loans?"

This question caught my attention as I read through reader emails this weekend. 

Margin loans can be particularly risky during bear markets. And if you're not careful it's possible to lose more money than you started with. Yikes!

With that said, margin can be a helpful tool under the right circumstances. And like any powerful tool, it's important to know how to use it appropriately.

So this week, we'll start with a great topic that R.S. brought up. 

And throughout the week, I'll answer more of your questions as we work our way through this bear market season.

What Is a Margin Loan?

A margin loan is a financial tool that most brokerages offer. With a margin loan, you can borrow cash from your broker to buy shares of stock.

A broker will typically allow you to borrow up to 100% of the value of your account. 

So if you deposited $100,000 into a brokerage account, you could then buy $200,000 worth of stock. (You would be borrowing $100,000 to essentially double your buying power).

Some brokerages allow you to borrow much more. And in most cases, your loan is secured by the value of stocks that you hold in your account.

When stocks trade higher, this can be a great tool. With a margin loan, you can buy more shares and lock in bigger prices as your investments add up. That's exciting!

However, during bear markets, a margin loan can cause some big headaches.

Buying shares on borrowed funds can magnify your losses which add up quickly.

Let's think about that $100,000 account with the $100,000 margin loan. Suppose you bought $200,000 of stock and then your shares all dropped by 20%.

The 20% decline would cause you to lose $40,000 from your investment. But you'll still owe your brokerage account the $100,000 you borrowed. 

So now even though the market only dropped 20%, you're left with only $60,000 in value. That's a 40% decline. 

Now you see why this tool can be dangerous in a bear market.

If you lost too much with a margin loan, your brokerage may even ask you to add more cash to your account. 

This is called a margin call. And if you don't comply, the brokerage may sell your shares to make sure you keep enough money to pay back the loan.

Ok, now let's dive a bit deeper into the question that R.S. sent me.

Proper Ways to Use Margin

The email I received from R.S. told me some important things...

First, R.S. has been buying high-quality stocks. That's good news. 

Because stocks of good companies that generate reliable profits are less likely to fall as far as the speculative stocks I've been trying to convince you to avoid.

Next, R.S. had extra funds available to add to the brokerage account. This is also helpful. 

Some people like to use a margin account to buy more shares. But they still keep the capital available for the shares in a different account. 

This leaves more cash available for day-to-day expenses while also allowing them to invest the full amount that they’re comfortable with.

And finally, R.S. has been selling call contracts to generate income from the shares. What a smart way to handle this situation! 

When you sell a call contract, you receive up-front income in exchange for your agreement to sell your shares at a specific price (for a specific time). 

This is a great way to help reduce the risk of your stocks falling and add more cash to your account.

I'm using the question from R.S. as a broad example for all of us to think about. So no part of this alert should be considered personal investment advice.

But we can use this example to help us understand how to use the tool of margin properly.

Managing Risk and Your Personal Comfort Level

Above are three reasons I like the way R.S. has used margin.

Investing in high-quality stocks, having extra cash handy, and using other strategies to generate income can help you use margin wisely.

But it's important to remember that using margin still adds risk to your account — especially in a bear market!

R.S. expressed some concern with the declines in his account. And when you're using margin, it's especially important to consider how much risk you can handle.

(I'd prefer you to think through this carefully before using margin and before a bear market hits. But we're in this situation right now, so let's think about a wise strategy from here.)

If you've been using margin and you find yourself uncomfortable with the amount of risk (or the size of the swings) in your account, it's probably time to set a plan for reducing your exposure.

In other words, selling some of your shares and paying off some (or all) of your margin loan. But I wouldn't do it all at once!

Remember, you never want to make an emotional decision — especially not at the exact wrong time.

A Smart Way to Reduce Your Risk

Instead, consider using one of my favorite tools I've talked about here at the Rich Retirement Letter — but using it in reverse!

Dollar-cost averaging is a strategy for slowly buying over time instead of all at once. 

This is a great way to ensure that you get some shares right away. But it also gives you a chance to buy more at a cheaper price if the stock goes lower.

When selling some shares because you're uncomfortable, you can use a similar strategy.

Start by deciding how much you want to sell. (Your investments should be safe enough to allow you to sleep well at night without worrying.)

Then set a time frame for when you want to be settled with this much invested. (Maybe two or three months from now.)

Finally, spread your sell orders over this period so that you slowly reduce your risk.

Sell a little bit this week, a bit more next week, and so on...

That way if the market spikes higher over the next few days, you won't kick yourself for getting out too early.

But if the market heads lower, you'll have already started selling some of your positions so that the losses won't be quite as bad. 

And you'll feel better knowing you have a solid plan for managing your risk in this turbulent environment.

Again, this isn't individual investment advice for R.S. or anyone else. But it does give you some good concepts to better manage your risk in today's market.

Please be sure to send in your questions this week! And I'll be back to you tomorrow with another bear market email that we can discuss.

Here's to living a Rich Retirement,

Zach Scheidt

Zach Scheidt
Editor, Rich Retirement Letter
RichRetirementFeedback@StPaulResearch.com

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