Investment Loan Risk Reduction for Higher Net Profits

An investment loan is a form of lending performed by brokerage firms that permit an investor to borrow money against securities held, in order to buy more securities. These loans, which are governed under Regulation T margin rules maintained by the Federal Reserve Bank, make it possible for an investor to take advantage of changes in the market in order to earn a profit and increase their shares of a particular security.

Borrowing Under Regulation T

All investments involve risk, regulation T also involves a certain amount of risk. These risks are associated with the uncertainty of the stock market and whether an outstanding loan is subject to a margin call, due to a drop in the portfolio’s value. Conversely, a general rise or fall in the market based on the portfolio’s position may produce a positive credit or excess equity, which can be used by the investor as a profit.

Managing Risk
Reducing the investment loan risk can be accomplished by maintaining a proportionate amount of equity relative to the Regulation T margin requirement. In general, an investor may borrow up to 1/2 the value of the securities in the margin account (with certain exceptions). This allowance means that an investor can deposit 1,000 shares of ABC stock when it is valued at $50 per share and borrow $25,000 as a margin loan. The $25,000 can be used to purchase additional shares of ABC stock or for any other purposes.

Increase in Portfolio Value

If the market price of ABC rises to $60 a share, this results in an increase in the portfolio’s market value to $60,000, creating an additional $10,000 in equity. Since only $30,000 in equity is required under Regulation T (50 percent the market value), the excess equity of $5,000 is posted in the Special Memorandum Account (SMA). SMA is the net profit that the investor receives and is available for any purpose.

Decrease in Portfolio Value

If the market value of ABC falls to $40 per share, this will cause a drop in the portfolio’s value to $40,000, decreasing the equity to 37-1/2 percent of the value or $15,000. Although the equity is above the minimum maintenance requirement of 25 percent, it is restricted until the equity is increased.

Your investment loan risk can be reduced when subject to losses such as those stated above by depositing additional securities or cash in order to increase the market value of the portfolio. You may also consider buying a put option against the portfolio in order to hedge against the downside portfolio risk. A put option is an option to sell.

Words of Caution
Using an investment loan in the form of a margin account in order to create a high net profit may be accomplished but should be done under the guidance of an experienced investor or stockbroker who understands the nature of the risks associated with margin loans.

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