Investing in the equity market with borrowed money is one such option. The article will focus on credit obtained through your stockbroker firm.
How does a stockbroker firm extend credit?
A stockbroker firm is allowed to extend credit to its clients for the sole purpose of purchasing securities traded on the Colombo Stock Exchange (CSE), provided that the total value of the credit extended will not exceed three times of the adjusted net capital. In order to obtain credit, you have to sign a credit agreement.
What is a credit agreement?
If you require credit from the stockbroker firm, you should enter into a written agreement with the firm. The agreement will clearly set out the applicable terms and conditions. The agreement should be read carefully. Each stockbroker firm will have its own structure but almost all of them will entail your contact details, National Identity Card number, applicable interest rates, provisions on terminating or amending the agreement, etc. Never sign on the dotted line until you understand the terms and the impact these terms would hold towards your portfolio. Your advisor will assist you in reading and understanding the agreement. Amendments to this agreement should also be in writing.
What is cost of credit?
Obtaining credit from your stockbroker firm is similar to a loan you obtain from a bank. Thus, even in this situation, you will have to pay a certain amount of interest that is predetermined by the stockbroker firm. The interest rate will be stated in the agreement you sign. Bear in mind that you would have to pay interest as well as the initial capital when you trade on credit. In certain situations, interest rates will be higher than the average market return. In such circumstances, credit becomes less profitable. Hence, it is always best to assess profitability prior to deciding on obtaining money on credit.
Why use credit?
It’s all about leverage. Just as companies borrow money to invest in projects, investors can borrow money and leverage the cash they invest. If you pick the right investment, credit can dramatically increase your profit. However, the situation will be different if the stock price goes down. In such situations, your profits might reduce.
The best way to demonstrate the power of leverage is with an example: Company ABC PLC is trading at Rs.2 per share. You have Rs.100. You can purchase 50 shares. What if your stockbroker firm lends you another Rs.100 on credit? You will be able to purchase another 50 shares. This increases the total to 100. We will now assume that price of a share goes up to Rs.4. What would your profit be?
Situation 1 - Investing with your own money
Rs.4 * 50 = Rs.200.00
Situation 2 - Investing on credit
Rs.4* 100 = Rs.400.00
As you can see, your profits have increased in the second situation. However, net profit will be calculated after you deduct the interest you paid for Rs.100.
Is there any collateral involved?
Yes. The credit extended to a client by a stockbroker firm will be secured by collateral, which comprises of securities held in the client’s CDS account. The credit extended to a client will amount to 50 percent of the market value (value of the securities pledged by the client, marked to market at the end of each market day, which is pledged by the client, to secure the credit).
Can stockbroker firm sell your shares?
According to section 7.1.3 of Stockbroker Rules of the CSE, a stockbroker firm is expected to give the client a margin call if the market value of the securities pledged by the client falls by 25 percent. The margin call will inform the client to meet the shortfall by the next market day. If by chance the client fails to meet the shortfall on the next market day, the stockbroker firm has the authority to immediately sell the securities which have been pledged by the client.
How can you keep track of your portfolio?
The statement of accounts would enable you to monitor your credit. A stockbroker firm sends a statement of accounts to all clients who are debtors over trade day + 3 (T+3), on a monthly basis by the seventh day of the following month. This applies to all debtors over T+3, who have had transactions during the month and the ‘interest charged on delayed payment’ is also considered as a transaction. It enables investors to manage their debt and to monitor the interest charged on the debt. It is advised that investors update themselves on these statements and act immediately if there are any discrepancies.
Is there a risk involvement?
If the stocks you have purchased through credit go up in price, you have made a good move. What will happen if the price decreases?
Let’s try to understand it through an example:
You borrow Rs.1000 from your stockbroker firm. A share of company GHI PLC is Rs.5. You can purchase 200 shares from the money you borrowed.
What if the price goes down to Rs.4 and you decide to sell it. You would receive Rs.800.00 (200*4). In this situation, your cost (Rs.1000 + interest charged) is higher than what you earned. What if you get a margin call and you are unable to comply with it? They will force sell your stocks. This would increase your losses further.
How can you minimize risk?
The risk involvement greatly depends on how you manage your credit. The tips given below will assist you to minimize your risk.
- Borrow within limits. Never go beyond your financial capacity even though investment opportunities seem lucrative. This was a mistake made by investors during the market bubble we experienced after the war. If you trade beyond your limits, you will not be able to comply with margin calls (if you receive any). This would lead to force selling that would affect the market adversely.
- Trading on credit involves a great deal of skill and knowledge on the market. Thus, it is best for seasoned investors.
nIt is always best to look at fundamentally strong stocks when you trade on credit. Usually penny stocks decrease faster than fundamentally strong stocks during a bear market.
- You should refrain from purchasing stocks that are overvalued. Market forces might push the price down to the intrinsic value.
- Think twice before you obtain this facility during a bear market as there is a higher tendency for prices to decrease. In such market conditions, you might receive margin calls and at times the stockbroker firm might force sell the stocks. The situation might intensify further due to the interest you pay.
- Constantly monitor your stocks. Trading on credit requires work. Monitor the price of the securities on a daily basis. If you see that the securities in your account are declining in value, you may want to consider depositing additional cash to avoid a margin call. If you receive a margin call, act promptly to satisfy the margin call.
- Have a payback plan for your debt. Loans against your investments mean that you’re paying interest. Your ultimate goal is to make money and paying interest eats into your profits.
What will you do if you have a complaint?
You could raise your complaints to the compliance officer of the stockbroker firm in writing at your earliest.
Investment advisors and stockbroker firms maintain professionalism. Yet, when dealing with them you might encounter certain incidents that you are not that comfortable with. There can be incidents were investment advisors trade on credit even when you haven’t signed a credit agreement. In such circumstances, you have to report to the compliance officer in writing at your earliest. If you keep silent when earning profits and complain when you incur losses, you can’t expect remedial action from relevant authorities.
Is ‘credit’ the trading edge you’ve been looking for? The decision is in your hands. Decisions should be based on your personal risk-return trade off. Yet, bear in mind that it entails a certain degree of risk, which could be minimized if you take necessary precautions.