Last time we conducted a thought experiment to understand how margin trading enhances the 'boom' and 'bust' scenario. We discovered in the end that even the savvy Mr. Operator could not walk away with profits despite the stock (Remember? Example Drugs Ltd. EgDg Ltd) trading higher than his first purchase price
Did something strike you in that example?
The most striking thing about the thought experiment was the obvious cascading affect of leveraging when the tide reverses.
However, what could have dampened the fall of the market?
Let us start with the basics - after all it was all about leveraging, the same old principle that Archimedes spotted.
A 15% margin implied that Mr. Small Fry could leverage 6.67 times. In other words, a trader with a capital of Rs1lac can take an exposure worth Rs6.67lac.
What if the margin got raised to 30%?
In that case, Mr. Small Fry would have been able to take an exposure worth Rs3.33lac instead of the Rs6.67lac. Hence, the sting of a devastating affect of over-leveraging in a falling market would have been removed.
Lost a little bit? Let us get back to the example.
Last time, we saw how Mr. Small Fry tracked the activities of Mr. Operator and jumped on to the bandwagon. Though he missed the first run from Rs100 to Rs140, he also took the plunge on June 14, 1999. His position appreciated by the end of the settlement as the price appreciated to Rs165. He used the 'havala' cash inflow to take additional exposure the following week.
The stock gained the following week too, and our friend increased his position further. We have captured how he increased his exposure in the table below. Of course, for the many of you who ran through it last time, skip it.
Table 1
| Mr. Small Fry | His Capital 100000 | ||||||||
| | Eg. Dg. Ltd. | Org. Cap. | Org. Exposure | P&L | Addln. Exp. | Total Exp | Net Cash Flow | Remarks | |
| | Mkt. Price | | (Marked to Mkt.) | (Havala Diff.) | (Marked to Mkt.) | | | | |
| 14-Jun-99 | 140 | 1.00 | 6.67 | | 0.00 | 6.67 | -1.00 | | |
| 19-Jun-99 | 165 | 1.00 | 7.86 | 1.19 | 0.00 | 7.86 | 0.19 | | |
| 21-Jun-99 | 171 | 1.00 | 8.14 | | 7.94 | 16.08 | -1.00 | 15% | |
| 26-Jun-99 | 180 | 1.00 | 8.57 | 0.85 | 8.35 | 16.93 | -0.15 | | |
| 28-Jun-99 | 185 | 1.00 | 8.81 | | 5.64 | 14.45 | -1.00 | 20% | |
| 03-Jul-99 | 155 | 1.00 | 7.38 | -2.34 | 0.00 | 7.38 | -3.34 | | |
| Final Cash Flow | | 1.00 | 0.71 | -2.34 | | | -0.63 | | |
| (All figures in Rs. Lac) | |||||||||
We also saw in the end that the tide reversed, and the stock price fell from Rs185 to Rs155. Mr. Small Fry got caught in the bind. In the end, he had to bridge a negative cash flow of Rs2.34lac. In order to meet this cash deficit, he had to sell his original position.
This wiped out his capital and the profit that he still had on his original position. Even then, he had to mobilise Rs63,000 by selling his family gold.
Now let us add a twist to the tale.
Mr. Regulator has this job of ensuring some semblance of sanity in the market. He polices the market to ensure that there is fair play too. He also exercises control over the prime market leverage - margins!
As part of his job, Mr. Regulator had been closely watching the activity in EgDg Ltd. He was getting a little uneasy with the sharp spurt in the share's price - from Rs100 to Rs165 in just two weeks.
He realised that this speculation was going a little out of hand. He decided to increase margins to 30% from 15% on June 21, 1999 as the price of EgDg Ltd. ran up sharply to Rs171 from Rs100. He called it the 'volatility margin' as it was meant to curb the unabated speculation. As the frenzy continued unabated, he raised it further to 50% on June 28, 1999.
How did it make a difference to Mr. Small Fry?
Let us rework the numbers again for Mr. Small Fry
Table2
| Mr. Small Fry - Additional Margin | His Capital 100000 | ||||||||
| | Eg. Dg. Ltd. | Org. Cap. | Org. Exposure | P&L | Addln. Exp. | Total Exp | Net Cash Flow | Addln. Margin | |
| | Mkt. Price | | (Marked to Mkt.) | (Havala Diff.) | (Marked to Mkt.) | | | | |
| 14-Jun-99 | 140 | 1.00 | 6.67 | | 0.00 | 6.67 | -1.00 | | |
| 19-Jun-99 | 165 | 1.00 | 7.86 | 1.19 | 0.00 | 7.86 | 0.19 | | |
| 21-Jun-99 | 171 | 1.00 | 8.14 | | 3.97 | 12.11 | -1.00 | 15% | |
| 26-Jun-99 | 180 | 1.00 | 8.57 | 0.64 | 4.18 | 12.75 | -0.36 | | |
| 28-Jun-99 | 185 | 1.00 | 8.81 | | 1.27 | 10.08 | -1.00 | 20% | |
| 03-Jul-99 | 155 | 1.00 | 7.38 | -1.64 | 0.00 | 7.38 | -2.64 | | |
| Final Cash Flow | | 1.00 | 0.71 | -1.64 | | | -0.08 | | |
| (All figures in Rs. Lac) | |||||||||
Though the first time Mr. Regulator raised margins, Mr. Small Fry must have cursed him to no ends. But, he must have had better words to use when he actually saw the outcome. Since he was unable to take bigger positions, he did not lose as much when the market dropped. Though he lost his capital in funding the cash flow gap, he was still able to get away unscathed. Remember in the previous instance, he had to sell his family gold to fund the loss of Rs63,000.
Hey, wait a minute. Haven't we all seen that the market falls when the margins go up?
Why?
The market's sentiment takes a beating as traders cannot take those bigger positions that they would like to. Hence, that must have had a dampening affect on prices, in this case, on the price of our good old EgDg Ltd.
In other words, the price would not have moved like Rs100-135-140-165-171-180-185 and then fallen all the way to Rs155. Instead, it was likely to have moved more like Rs100-135-140-165-175-176 and then fallen to Rs155.
How does Mr. Small Fry fare in such a situation?
Table 3
| Mr. Small Fry - In Reality | His Capital 100000 | ||||||||
| | Eg. Dg. Ltd. | Org. Cap. | Org. Exposure | P&L | Addln. Exp. | Total Exp | Net Cash Flow | Addln. Margin | |
| | Mkt. Price | | (Marked to Mkt.) | (Havala Diff.) | (Marked to Mkt.) | | | | |
| 14-Jun-99 | 140 | 1.00 | 6.67 | | 0.00 | 6.67 | -1.00 | | |
| 19-Jun-99 | 165 | 1.00 | 7.86 | 1.19 | 0.00 | 7.86 | 0.19 | | |
| 21-Jun-99 | 171 | 1.00 | 8.14 | 0.00 | 3.97 | 12.11 | -1.00 | 15% | |
| 26-Jun-99 | 175 | 1.00 | 8.33 | 0.28 | 4.06 | 12.39 | -0.72 | | |
| 28-Jun-99 | 176 | 1.00 | 8.38 | 0.00 | 1.57 | 8.95 | -1.00 | 20% | |
| 03-Jul-99 | 155 | 1.00 | 7.38 | -1.07 | 0.00 | 7.38 | -2.07 | | |
| Final Cash Flow | | 1.00 | 0.71 | -1.07 | | | -0.65 | | |
| (All figures in Rs. Lac) | |||||||||
Mr. Small Fry takes less of a beating obviously as prices do not rise and fall sharply. In fact, Mr. Small Fry still walks home with more than half his capital intact.
We had seen for ourselves how unbridled trading, using leverage, creates 'boom' and 'bust' earlier.
This time around, we realised the importance of market regulation. Though Mr. Regulator's actions are scorned by the market, these very actions save the likes of Mr. Small Fry and perhaps prevent Mr. Suckers from getting in.
The other key learning is that trading without a proper game-plan can be dangerous. When the market corrects after speculative excesses, it does not even spare the likes of Mr. Operator.
Hence, margin trading can prove to be very fatal unless conducted the right way. In a different forum, we will let you know the precautions to be taken to save one's skin while still retaining a chance to profit.
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