Monday, September 10, 2012

Living On The Margin (3)

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Al Frank, in his book Al Frank's New Prudent Speculator, said that he used margin in his investing.  He did acknowledge its dangers, especially in a market decline:

There is no free lunch on Wall Street.  Well, hardly any.  Margined or leveraged stock results cut two ways.  Just a 25 percent increase in the market price of a portfolio yields a 50 percent increase in its equity -- at the 50 percent margined level -- so a 25 percent decline in market price would result in a 50 percent decline in equity at the same margined level.  This leverage can lead to even greater destruction on rare occasions such as the Crash of October '87 or the Selloff of '90.*

Shorting a stock is, essentially, the same use of margin in reverse.  Jesse Livermore made millions shorting stocks during market crashes.  I must assume that there were short sellers during the '87 and '90 drops mentioned by Mr. Frank, but their gains were far outstripped by the losses incurred by millions of others in the market during those dark days.

Frank said that he would heed margin calls and sell enough of his equity to maintain his margin positions if he felt strongly about his strategy with a stock.  Humphrey B. Neill held the opposite position.  In his book, Tape Reading & Market Tactics, he advised his readers as follows:

The Market Philosopher's advice to his class is: never answer a margin-call.  Tell your broker to sell enough of the shares he is holding for you to meet his requirements.  The margin-clerk is your best friend: he can be depended upon to tell you when to sell; and if you do not follow his tip, he will sell anyway.

In order to check up on this theory of its being best never to answer a margin-call, I once interviewed a number of brokers.  They all, without exception, told me that traders would fare much more profitably than they usually do, if they never replied with more money to protect their margin accounts.

And why should they not?

Your judgment is bound to be biased when your stocks are going against you.  It is impossible for you to consider all factors calmly.  When you purchased your stocks you expected them to advance.  If the opposite movement occurs, your judgment is wrong.  Then why, in Heaven's name, throw good money after bad?  What is the difference, after all, between a paper loss and an actual loss?  Your equity is exactly the same on the broker's book (minus the selling commissions).  You are no better off, holding on, than you are if you sell out -- in fact , you are not as well situated, because more of your capital is tied up; thus you weaken your position, possibly to the point where you cannot take advantage of whatever bargain prices there may turn up later.**

(Author's emphasis in bold)

As with every other investment strategy we have looked at, it all comes down to what makes the most sense to you as an individual investor.  If you feel comfortable using margin, then do so.  If it seems too dangerous for you, then don't.  Being a successful investor or trader on Wall Street requires that you have full confidence in your method of investing.  If you decide to invest on the margin, I suggest you take Neill's advice to heart and never return that call from your broker.

*  The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.

**  Excerpt from Tape Reading & Market Tactics, Humphrey B. Neill, republished by BN Publishing, pages 213-214.

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