Wednesday, August 8, 2018

Upping Your Game Level - With Margin Financing and CFD

In the spirit of supporting my good friend's Chris in his next upcoming talk on achieving financial independence with Reits, I have decided to do a blogpost on it which I've been wanting to do it but have very little time and interests in the past to do it.

If you still have not registered for Chris talk, you can register it here.

Margin Financing or CFD

In layman terms, margin financing or CFD simply means leveraging by borrowing money to build your portfolio in the hope that you will reap greater rewards.

There's a few margin financing services out there you can find. 

Maybank is one of them with the better ones, offering at 2.88% for Reits and some other Grade A stocks that they define, at a maximum of 3.5x leverage level on the amount of cash pledged.

For me, I have an account opened for CFD with Cityindex the past couple of years, which currently offers at 3.2% and able to leverage a maximum of 10x (trust me, you won't want/need this much leverage).

Typically, most margin calls will happen at < 140% based on the margin ratio of the total value of your shares worth divided by the amount of loan that you are undertaking.

In this post, we'll try to find the sweet spot by going through a few examples.

Example 1 - Purchase Singtel @ $3.20 with 2.5x leverage @ 3.2% financing

Let's assume you find Singtel price today at $3.20 very enticing but yet you have only $10,000 worth of cash to utilize.

With the cash you have, you are only able to purchase a total of 3,100 Singtel shares. Assuming they maintained their current dividend payout at $0.175/share, your annual dividend received would have been at $542.

Now, if you decide to venture a bit of a risk and go for 2.5x leverage on the amount of cash pledged, that will enable you to leverage up to $25,000 as loan, you would be able to purchase worth of 10,900 Singtel shares. Assuming they maintained the current dividend payout of $0.175/share, your annual dividend received would have been at $1,907. After netting off the interest paid (3.2% x $25,000) of $800, you would still receive a net dividend amount of $1,107, which is almost double the amount if you did not do any form of leveraging.

This is assuming price stays constant throughout.

Small Correction Scenario

Let's give a bit of variation to make the case interesting.

Let's assume there is a small correction in the market and the share price of Singtel drops from $3.20 to $3.00, a drop of about 6.5%.

If you are buying on full cash, then it'll just be a temporary paper loss for you, unless you decide to cash out. If you think Singtel is worth higher than what the market perceives, then all you need to do is to hold on and wait for the rebound to take place.

However, if you are buying this on the margin scenario above, then your value of Singtel is now worth $32,700.

Since $32,700 / $25,000 = 131%, which is less than the <140% margin ratio, you would get a margin call to top up the difference back.

This is usually when investors are screwed, because they are either caught by surprise, do not have extra cash, or forced to sell off their holdings at the loss (no more paper loss at this point).

Example 2 - Purchase Singtel @ $3.20 with 1.5x leverage @ 3.2% financing

What happen if we lower down the leverage to 1.5x in this example.

This means, using $10,000 as pledged, we borrow a further $15,000 to purchase at 3.2% interest.

This would enable us to purchase 7,800 Singtel shares worth at $3.20.

Should a small correction happens and Singtel price drops to $3.00, your shares are now worth $23,400 and your margin ratio would be $23,400 / $15,000 = 1.56, giving you a nice cushion of buffer to allow rebounds to happen.

In this scenario, your Singtel share price would need to fall below $2.69 before you get your margin call and the need for top up.

Recession Scenario

In a recession type of scenario, it is likely that we will see Singtel breaks below $2.69 and thus you are likely to also face a margin call, which happens a lot during a major crisis in the past.

Using the GFC as a benchmark, we have seen Singtel drops as low as $1.99, which would mean your margin ratio would have been at $15,522 / $15,000 = 103%.

Example 3 - Purchase Singtel @ $3.20 with 0.8x leverage @ 3.2% financing

This is if you want to play very freaking safe but yet die die still wants to leverage on your capital.

Assuming you have $10,000 cash pledged as capital, and wants to borrow $8,000 as your loan, you would have 5,700 Singtel shares worth at $3.20.

Should GFC comes and your Singtel shares drop to $1.99, your shares are now worth $11,343 and your margin ratio are now worth 141%.

To me, this is the safe level, the same concept on how your Durex condom sells based on the probability level.

Of course, with 0.8x leverage, your reward is very much reduced too.

Pre-requisite Criteria

There's a few pre-requisite criteria you should have before you even want to venture into this sort of area.

First, you need to be selectively good in your stock picking.

If you suck in your selection of stocks in your current all cash portfolio, then likely is your suckness level will get multiplied in the leverage tool. If you suck in stocks selection, you'll lose out either way in your today's portfolio or in your leverage portfolio.

Second, you still need to ascertain a buy with some level of margin of safety.

The above example we used earlier is buying Singtel at the current today closing price of $3.20. If you had bought Singtel at a much higher price (say $3.90) using leverage, then likely not even 0.8x leverage will give you enough comfort.

If you use the 0.8x leverage method during the peak of the financial crisis, then likely your safety level is even higher than the Durex condom promise they can give you.

Third, my criteria is to buy companies that pays out at least 3.2% worth of dividend yield to minimally covers the interest track I am paying. This ties back to the type of stock I am interested in and also the valuation level based on the second point.

Last but not least, the mental needs to work together with you.

There'll be lots of shit stirred from the news and your friends and you just need to work out the maths to ensure this works out to your advantage.

After all, we are all leveraging already when we bought our home purchase right?

Thanks for reading.

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  1. Your housing loan got margin call meh? And to top up margin call before 5 pm or force sell the next trading day.

    1. If I am not wrong, if your property value fall significantly and the original loan to value ratio is exceeded, the bank will ask you to topup or pay off some of the outstanding loan.

    2. Hi Uncle CW

      I’d argue from the view that the margin call isnt the killer in taking margin financing.

      It’s the plan in front that didnt work out well that kills the margin financing folks.

      With property, if you buy at the peak of the valuation, no margin call will also kill you on your lifetime of repayment.

    3. Leverage itself doesn't kill. It is after tasting good success; why not more leverage? Why wait? FIRE sooner! Greed and front running success kills them!

  2. I don't think there's anything inherently wrong with leverage - but it's the specific tool you use that can cause you pain.

    Mortgages to leverage on property values generally don't cause serious issues because as long as you meet your monthly payments, it doesn't matter what the asset value does. Very different story when it comes to margin lending - which I dabbled in many years ago and learnt the hard way. Too easy to think you're invincible after a few successful investments, but that can all be blown up with a margin call at the wrong time when you least expect it.

    Cheers, Frankie


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