“Buying on margin is bad. It will ruin you.” Recently, somebody asked a question whether they should use margin, and the consensus was no. I wonder. Are there not specific cases where strategic margin usage with risk awareness can be a good idea?
Let's assume the following:
Long term S&P 500 return rate: 7-8% (that's conservative, historic averages are more like 9-10%)
Margin cost: 3% (IBKR currently charges 2.9% for me)
Maximum downturn over 10 years: 30%
My hypothesis is: If I am careful enough, I can increase my returns without too much risk.
Let's say I suck at individual stock picking, so I stick to SPY. I have an investment horizon of at least 10 years. In normal times, I DCA. But once I see that the market has fallen significantly, I start using margin. But carefully. I use up to 10% of my margin, but only when the price is low, that is when the market is down. If the market turns down more, I stop buying on margin until I have more collateral.
So…what's the chance of a margin call?
Given those parameters, say I have $100k invested in SPY, 0% margin. I can use a collateral of 75%, that's $75k. So I see an opportunity for margin investment. Maintenance margin requirement for SPY CFD is 10%. That means with an additional exposure $75k in SPY CFDs just in margin, I have a margin usage of 10%. And I just doubled my exposure.
Now the market loses another 30%. My margin collateral shrinks to $52.5k. Also, my CFDs have a loss of $22.5k. So my remaining margin is 30k.
However, I just need $5.25k for the SPY CFD. My margin usage turns to 18%. Which is far away of something to worry about.
Can the market turns down even more? Well, I already bought the CFD when the market is down from its ATH. Also, 30% loss of S&P 500 doesn't happen over night. So in most cases, I would be able to bring in new cash.
So by limiting myself to 10% margin usage, I can double my exposure (and gains minus margin costs), with minimal margin call risk. I would even say that 15% works with those assumptions, but then the margin usage of a 30% downswing would be 42%. A downswing of 37% is game over.
What are other risks:
Margin costs eating away my profits: Since I still use my money on SPY for collateral and wouldn't hold too much cash, I should not forego profits on the non-margin traded part of my portfolio.
For the CFDs, as long as the average, 10 year return rate of S&P 500 is above the margin rate, then I still make a profit. With the assumptions above, that's an extra 3-4%, which is quite significant.
However, the way the risks are structured, when the cost of money and the bond rate goes up, the market return goes down. As long as the rate goes up only 1-2%, I should be good. Anything more and the margin costs will exceed the gains from my CFDs. That's the main gambling part of the strategy.
Apart from that, there is the usual risk of “my financial planning is stupid or insufficient and I suddenly need the money from my portfolio”. Or “I forget to close the margin positions at a convenient time, because I am lazy or greedy.”
Do I miss something else? Is that strategy still too risky? Are my assumptions totally off?
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