In my investing journey, I've had my ups and downs with margin. While margin can amplify gains, it can also magnify losses, as I've learned firsthand from painful experience. So, I have retooled my approach and sharing my new, more conservative approach to margin, which I am calling the "Cautious Quarter" strategy.
The Problem with Traditional Margin Rules:
The problem with margin rules is that I could not find any. Consulting with Gemini LLM, it spit out the "1/3 rule", which I think is a hallucination. There are no search results that support the 1/3 rule other than in photography. What this means to me is that I'm on my own to figure out the optimal amount of margin for trading that minimizes my chances of getting a margin call.
My "Cautious Quarter" Solution:
I trying a the 1/4 margin approach with two key principles:
- Low Ratio: I will use a 1/4 ratio (25%). This inherently limits my leverage and potential losses. Of course, these would not be constant margin levels, only peak. I would endeavor to pay down the margin loans as quickly as possible.
- Protected Base: I will apply this ratio only to the excess equity in my account over the initial amount required for margin trading (which is, $2,000). This ensures a reasonable foundation and reduces the risk of margin calls further.
How it Works:
• Example: If my account has $10,000, I have $8,000 in excess of the initial $2,000. I then calculate 25% of this excess, which is $2,000. This is the maximum I would borrow on margin.
Benefits of this Approach:
• Enhanced Risk Management: Lower leverage means smaller losses if the market takes a downturn.
• Greater Margin of Safety: Protecting my initial capital provides a buffer against margin calls, even with moderate market fluctuations.
• Increased Control: I have more flexibility to handle market volatility without being forced into selling positions at a loss.
Fly In the Ointment
My plan is not completely without risk. During market crashes, it is possible that brokerages will raise their margin requirements to lower their own risk. In this case, I would be squeezed from both sides. On one side I'd have falling equity. On the other side I'd have reduced credit.
In Practice
In practice, I would likely limit margin use to the $1000 interest-free amount available from Robinhood. If an opportunity arises, I could increase margin borrowing to a peak of 25%, if that.
Why This Strategy Works for Me:
• Aligns with my risk tolerance: As someone who's experienced the downside of margin, I prioritize capital preservation and steady growth over aggressive gains.
• Suits my investment goals: My focus is on long-term dividend income and building wealth gradually.
• Provides peace of mind: This cautious approach allows me to sleep soundly at night, knowing my portfolio is more resilient to market shocks.
Important Disclaimer:
This strategy is what works for me. It's crucial to find a margin approach that aligns with your own risk tolerance, financial goals, and individual circumstances. Always do your own research, monitor your account diligently, and be prepared to adjust your strategy as needed.
What do you think of the "Cautious Quarter" strategy? Share your thoughts and experiences with margin in the comments below!