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Rediscovering Volatility

by on March 04, 2018 5:00 AM

For those following the stock markets in 2018, market volatility has returned with a vengeance. The past several years of calm uptrend was abnormal and now we are back to the way equity markets are supposed to be. Stocks have risk and that’s why they have higher rewards.

One of the main culprits of greater volatility is margin. Margin is the ability for investors to borrow from their positions to buy more securities. They use their existing holdings as collateral. Initially, with most publicly traded, big name stocks, brokerage firms require 50 percent equity.  

As an example,  if you own $5,000 of Apple (AAPL), you could buy $2,500 Colgate Palmolive (CL) without using your own money to buy CL. If the stock prices fall, the investor may have to put their own money in or sell securities if it falls below 35 percent (This percentage may vary by firm and security). This is called a margin call. Buying on margin allows an investor to amplify their returns, like the ability to buy a house with 20 percent down payment where you would be able to buy more house because you are borrowing to fund it.

However, this also amplifies the downside. Brokerage firms like margin because they can make money from the interest they charge you for the loan. Therefore, be careful when being offered a margin account because firms have an inherent conflict to offer margin and make more money.

Because they carry higher risk, margin accounts are not for everyone. You could lose more money than you invested; you may have to deposit additional cash or securities to cover a margin call (your account falls below the 35 percent margin requirement); you may have to sell securities to cover a margin call; or the brokerage firm may sell your securities without consulting you to cover a margin call.  

So, how does margin create more volatility? The old adage on Wall Street is to never meet a margin call.  This means rather than putting more money into an account to retain securities bought on margin, you sell assets. This can intensify a downturn as investors must sell solid assets to cover the loan requirement. This is part of the reason the 2000 tech bubble burst and that the 2008 real estate downturn was so severe. People had to sell good, solid companies that they might otherwise have kept but had to sell in order to cover the loans (margin) they took to buy more stocks.

A Wall Street Journal article, Investors’ Zeal to Buy Stocks with Debt Leaves Markets Vulnerable,” by Michael Wursthorn and Chelsey Dulaney, zeroed in on the record-breaking margin being used currently. Investors have $642.8 billion borrowed against their portfolios. Because margin loans amplify returns to the upside and downside, they amplify volatility in the markets. People can buy more securities to the upside as their equity increases. However, those same investors might need to sell assets when the market falls, exacerbating market ups and downs. The size of overall margin loans is catching the interest of industry watchdogs, including FINRA (the regulatory agency over brokerage firms). FINRA published an investor alert in January warning investors of the dangers of margin.

Another main cause of volatility is electronic trading. Hedge funds, big investment firms and others use powerful computer algorithms to do high frequency electronic trades and automatically sell or buy when the markets or a stock meet certain prices. When such large orders automatically execute, they can intensify the upside or downside in the markets.  

The markets try to protect against panic selling by implementing market-wide circuit breakers (or collars). If the markets fall to certain levels, trading can halt for 30 minutes or even close for the day. This allows traders and investors to get their ducks in a row and stop emotional trades. Circuit breakers were initially put in place after “Black Monday,” Oct. 19, 1987, when the market plunged 22.6 percent in one day.

Volatility is inherent in the stock markets and should be fully expected by those investing in equities. If the recent volatility scared you and makes it hard to sleep, you need to lower your exposure to more volatile assets. Given the recent tumult in the markets and large gains, it may be time to check your risk tolerance and whether you need to reallocate and sell some of your risky assets.


 

 



Judy Loy, ChFCâ, is a Registered Investment Advisor and CEO at Nestlerode & Loy Investment Advisors, State College, Pa. A graduate of Penn State University, Loy has been with the firm since 1992, assisting clients with retirement planning, brokerage services and investment advice. She can be reached at jloy@nestlerode.com.
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