Monday, September 3, 2012

Living On The Margin (2)

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In the last blog on margin loans, I gave a simple explanation of the process.  You may remember earlier blogs about Jesse Livermore, the famous 1920's trader who made and lost millions trading on margin.  Edwin Lefevre's thinly disguised book about Livermore, Reminiscences of a Stock Operator, included the following lesson on margin trading:

People don't seem to grasp easily the fundamentals of stock trading.  I have often said that to buy on a rising market is the most comfortable way of buying stocks.  Now, the point is not so much to buy as cheap as possible or go short at top prices, but to buy or sell at the right time.

Let us suppose, for example, that I am buying some stock.  I'll buy two thousand shares at 110.  If the stock goes up to 111 after I buy it I am, at least temporarily, right in my operation, because it is a point higher; it shows me a profit.  Well, because I am right I go in and buy another two thousand shares.  If the market is still rising I buy a third lot of two thousand shares.  Say the price goes to 114.  I think it is enough for the time being.  I now have a trading basis to work from.  I am long six thousand shares at an average of 111 3/4, and the stock is selling at 114.  I won't buy any more just then.  I wait and see.  I figure that at some stage of the rise there is going to be a reaction (he means a price drop).  I want to see how the market takes care of itself after that reaction.  It will probably react (he means a price rise) to where I got my third lot.  Say that after going higher it falls back to 112 1/4 and then rallies.  Well, just as it goes back to 113 3/4 I  shoot an order to buy four thousand -- at the market of course.  Well, if I get that four thousand at 113 3/4, I know something is wrong and I'll give a testing order -- that is, I'll sell one thousand shares to see how the market takes it.  But suppose that of the order to buy the four thousand shares that I put in when the the price was 113 3/4 I get two thousand at 114 and five hundred at 114 1/2 and the rest on the way up so that for the last five hundred I pay 115 1/2.  Then I know I am right.  It is the way I get the four thousand shares that tells me whether I am right in buying that particular stock at that particular time -- for of course I am working on the assumption that I have checked up general conditions pretty well and they are bullish.  I never want to buy stocks too cheap or too easily.

If you take nothing else away from that passage, you should recognize that trading like this is a full time job for a professional, not an "every so often" grab for quick profits by an amateur dabbling in the market.  Benjamin Graham (I called him the Godfather of fundamental investing) was very blunt in his assessment of using margin.  He said it was not investing, it was speculating.  If you are a long term investor, you should probably stay away from margin.  If you choose to trade on margin successfully, the most difficult task you will face is convincing your spouse that you can give up your day job.

We will take a final look at margin in the next blog.

Excerpts from Reminiscences of a Stock Operator, Edwin Lefevre, 1923, republished by John Wiley & Sons, Inc. in the Wiley Investment Classics series.

Comments are always welcome.

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