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Tuesday, March 29, 2005
Market Recap
Well, I hate to be the baron of bad news but as I mentioned in yesterday's commentary, I did not think this small rally would last and today the indices caved in as the sellers did not let up all afternoon. The NASDAQ is now firmly in bear market territory with today's decisive close far below its 200 SMA line, with an 18 point loss. The Dow lost 79 points and is moving closer to the 200 SMA target that I have identified before. I expect a bounce near this level but it is anyone's guess how much conviction buyers will have on the bounce. The 200 SMA for the Dow is 10376 with price support at 10368. Somewhere within this 8 point range is where I think the bounce will come. This area of support must hold up or we can turn out the lights as the party will be over in 2005. The S&P lost 8 points today and is sitting near price support around 1163. Its 200 SMA is only 13 points lower at 1150. Another day or two of selling and this market could be in store for a nice relief rally but, buyer conviction is what I will be looking for while we are rallying. If no conviction, the rally will fizzle and these indices will be below their respective 200 SMA's before you can ask “Does a bear short in the woods?”
Cash or Margin?
Since we are looking at a potential bear market, meaning loading up on short positions, should the indices close below their 200 SMA's, I thought it would be prudent to discuss margin accounts. You will need to have one if you plan to short sell stocks.
The Good, the Bad, and the Ugly of Margin Accounts
The Good
The good is obvious: when you want to make a purchase, the cash is available to do so. There is no worry about the settlement period and you are free to trade as frequently as desired.
The Bad
The bad is often overlooked. You are buying stock with money that you do not have or, if shorting, borrowing shares that you do not own. At some point, you will have to pay the money/shares back with an interest payment.
The Ugly
The ugly part is when you borrow money to buy a stock and that stock goes down, or up if you borrowed shares to short. Not only are you looking at a losing trading, but it is on borrowed money/shares. You have to pay back the loan and you can not sell or cover the stock for what you paid for it. That situation can get ugly fast.
During the Internet bubble, there were very loose requirements on margin borrowing. Investors borrowed many times the value of their account. The Internet bust wiped out a lot of investors who were on margin. Fortunately, we now have some very strict margin requirements to protect those who would otherwise use margin foolishly.
Margin Requirements
The SEC and brokerage firms now require you to have a certain amount of equity in your account to balance the debt load from margin borrowing. The broker requirement is typically called a “house” requirement. The SEC requirement is typically called an “exchange” requirement.
When you overextend your buying power, you face a margin call. You can get yourself into this situation by borrowing money and having your positions decline on you, thus giving you less equity. You have 5 days to settle the imbalance within your account. If you fail to do so, your broker will likely take action to cover the balance by selling shares in your account to get you back into a favorable equity position. In these cases, the brokerage will sell your stocks and may not make the best selling decisions. Instead, they take the “sell anything at any price” approach, selling however many shares required to cover your debt.
When we short positions, a margin account is needed because you are borrowing shares to sell short. You are borrowing something that you do not own and then selling it. The broker requires you to borrow from them on margin.
When using margin, you must be a very disciplined trader. Having a margin account can make all the difference in the world when you want to swing trade or short stocks in a declining market. Without margin, you are left on the sidelines during the settlement period. That is not the place you want to be if there is a sudden down draft in the markets or in a Bull market for that matter. Margin is a great tool if you know how to use it and if you are an active trader. You need a margin account to be effective.
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