Leverage ‘can rip your arms off,’ former TD Ameritrade boss says in warning to meme-stock retail traders

Joe Moglia
Joe Moglia, former CEO of TD Ameritrade and current chair of FG New America Acquisition.

  • “Leverage on the way up is a great thing. Leverage on the way down can rip your arms off,” former TD Ameritrade CEO Joe Moglia tells retail traders in meme-stocks in a CNBC interview.
  • Brokerage firms and financial houses dealing with retail investors must be better at educating their clients about the risks of leverage or using loans from brokers to buy stocks.
  • Moglia on Thursday addressed retail investors as AMC shares have rallied sharply in the last two weeks.
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Using leverage, or borrowing money to buy stocks, can pay off for retail investors participating in the explosive rallies in AMC Entertainment, GameStop and other so-called meme stocks but they need to be aware that those trades can quickly turn and burn them financially, the ex-head of TD Ameritrade said in a CNBC interview on Thursday.

“My biggest concern is what’s going on with the individual investor … and that they’ve got to be able to understand when they use leverage what that really means,” Joe Moglia, a former CEO and chairman of the online discount brokerage, told CNBC’s “Squawk Box”.

In using leverage, or margin trading, investors borrow cash from their brokerage companies to buy stocks and pledge securities in their accounts as collateral. Margin trading increases buying power and expands profits.

“Leverage on the way up is a great thing. Leverage on the way down can rip your arms off,” Moglia said, referring to losses that can hit investors when a stock price falls. He said investing platforms and other market professionals need to improve upon educating individual investors who day trade about the risks they face from market declines and how to handle them.

“A quick example: if you bought AMC at $10, and it goes to $20, is that not enough of a profit? It goes to $30, it goes to $40. At what time do you start to trim that position or, in effect, get rid of the position altogether? There are things that we’ve got to do a better job of with day traders,” said Moglia, who is the current chair of FG New America, a blank-check company, or SPAC, that targets opportunities in the fintech industry.

Moglia spoke as retail investors have launched AMC’s price up by more than 500% since late May in defending the movie-theater chain’s shares against hedge funds selling the stock short. The rally is reminiscent of the January boom in GameStop’s price as retail investors battled hedge funds betting against the video-game retailer’s stock. GameStop shares eventually retreated sharply from an all-time high of $483 apiece.

Investors can be vulnerable when the value of the stocks they’ve purchased drops significantly. Those declines can trigger margin calls, or demands by brokers for clients to repay some of the money they borrowed. Brokers can liquidate a client’s assets to cover the debt if they fail to meet a margin call.

Retail investors have lately overpowered short-sellers betting against AMC. Short-sellers lost nearly $3 billion on Wednesday alone as AMC’s share price more than doubled, according to data from analytics firm Ortex.

“What we’ve got to be conscious of is, at some point, the market is going to turn around. The technicals are going to wear out and [retail investors have] got to be prepared for a down move in that. But so far, I think they’ve pry made a little bit of money,” Moglia said.

Investors this year are borrowing all-time high amounts against their portfolios, with margin debt reaching $847 billion at the end of April, according to data from brokerage industry regulator FINRA.

Retail trading volumes, meanwhile, have been climbing on the back of growth in commission-free brokerage accounts and user-friendly trading apps and as millions of Americans forced to stay home because of COVID-19 turned to the stock market to make money.

Moglia said retail day traders overall should learn more about long-term investing strategies which can enhance discipline.

“If they love what they’re doing and they get burned a bit, that shouldn’t send them away from the market although I recognize that’s a risk. That should tell them they need a better education, a better understanding that day-trading alone is not going to be good enough to ride out the ups and downs of what’s going on with the economy and the markets over the next several years.”

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The man at the heart of the Archegos fiasco is a ‘Tiger cub’ and devout Christian who pleaded guilty to insider trading. Meet Bill Hwang.

Bill Hwang
Archegos co-CEO Bill Hwang.

  • Bill Hwang’s Archegos fund was reportedly hit by margin calls, sparking a brutal sell-off.
  • The “Tiger cub” is deeply religious and believes he’s doing God’s work by investing.
  • Hwang previously pleaded guilty to insider trading and was slapped with a trading ban.
  • See more stories on Insider’s business page.

Bill Hwang is the talk of the financial world after several Wall Street banks reportedly slapped his family office with margin calls last week, declared him in default when he didn’t pay up, and executed a $20 billion fire sale of his positions that hammered stocks including ViacomCBS and Discovery.

The deeply religious founder and co-CEO of Archegos Capital Management has run into trouble before. He pleaded guilty to insider trading in 2012, forked over $60 million to settle related charges, and closed down his fund. He was also banned from trading securities in Hong Kong for four years in 2014.

Here’s a quick look at Hwang’s life so far.

A religious upbringing

Hwang was born in the mid-1960s and raised as a devout Christian. His father was a church pastor and his mother served as a missionary in Mexico, he said in a 2018 interview promoting communal bible readings.

The fund manager smiles a lot, cracks jokes, and comes across as humble in the interview. He doesn’t take himself too seriously, but clearly feels a burning desire to spread the gospel.

Faith has guided Hwang’s entire career. He sees investing as his calling, and believes God “loves” when he backs companies that contribute to humanity’s progress. “It’s not all about money,” he said in another 2018 interview.

Hwang gave the example of one of his larger investments, Linkedin. He suggested that God loves the social-media group’s goal of helping people to find jobs and realize their potential.

“I’m like a little child looking for what can I do today, where can I invest, to please our God,” he said. Inspired by Jesus Christ tirelessly working for his father, Hwang added, “I’m not going to retire until he pulls me back.”

Hwang is involved in several Christian organizations. He’s the cofounder of the Grace and Mercy Foundation, a contributor to Focus on the Family, and a trustee of the Fuller Theology Seminar, the three groups’ websites show.

Becoming a tiger cub

Hwang holds an economics degree from UCLA and a MBA from Carnegie Mellon, an online biography shows. He worked as a stock salesperson at Peregrine Securities and Hyundia Securities early in his career, until he caught the eye of one of his clients, Julian Robertson. He soon went to work under the veteran investor at his storied hedge fund, Tiger Management, and became one of his protégés.

Robertson closed his fund in 2000, but handed Hwang about $25 million to launch his own fund, Tiger Asia Management. One of several “Tiger cubs,” Hwang grew his firm’s assets to over $5 billion at its peak, The Wall Street Journal says, and delivered an annualized return of 16%, according to Bloomberg.

However, Hwang shuttered the fund in 2012 after pleading guilty to insider trading in federal court that year. He paid a total of $60 million to settle civil and criminal charges of manipulating Chinese stocks, and his fund forfeited about $16 million in related profits.

Going private

Hwang converted Tiger Asia into a family office, Archegos, in 2013. The switch meant he no longer managed any outside money, slashing the regulatory disclosures required of him.

Archegos roped in several major banks to place leveraged bets on multiple stocks. However, the markets turned against the fund last week, prompting brokers to issue “margin calls” or demand more money as collateral. When Hwang failed to comply, the banks liquidated over $20 billion worth of his positions to recover their money, sparking a brutal sell-off across a dozen stocks.

The full scale of the fallout from Archegos blowing up won’t be known for a while. Yet it’s safe to say that Hwang is at the center of another fiasco that he would have preferred to avoid.

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A margin call means your broker is asking you to repay the money it lent you to buy stocks – and if you don’t, it could mean big losses for your portfolio

margin
If you can’t promptly meet a margin call by adding funds to your investment account, your broker has the right to sell some of your securities.

  • A margin call occurs when a broker demands repayment of some of the money it lent you to buy investments.
  • A margin call usually happens when the securities you bought have dropped drastically in value.
  • If you fail to pay the margin call, the broker has the right to begin liquidating your assets.
  • Visit Business Insider’s Investing Reference library for more stories.

Sometimes, stock market investors are able to borrow money from their broker to buy stocks or other securities. This tactic is called buying on margin, or margin trading

Margin trading increases your buying power and amplifies profits. 

But the possibility of encountering a margin call is the big “catch” of margin trading. Basically, it’s a request by your broker to pay back some of the money you borrowed – pronto. If you don’t, the broker can seize some of your portfolio’s assets and sell them. 

Before you begin using margin, you need to understand what margin calls are and why they can be so dangerous to your portfolio – and your finances. 

How does margin trading work?

But before we get into margin calls, a brief explanation of margin trading itself. 

When you buy an investment – stocks, bonds, exchange-traded funds (ETFs) – on margin, you pay some money in cash and borrow the rest, usually up to half of the purchase price. The investment itself is used as collateral for the money you borrow. It’s like when you take out a mortgage for a house: The new home is the collateral, or provides the backing, for the loan.

As with a house, your down payment – the amount of cash you furnished for the investments – is your equity or ownership stake.

To calculate your equity (in dollars), subtract your borrowed amount from the current value of your securities. For example, if you bought $12,000 of securities using $6,000 of cash and $6,000 of margin, your initial equity would be $6,000:

$12,000 (value of securities) – $6,000 (borrowed amount) = $6,000 (equity)

And to find your equity percentage, you’d simply divide your equity by the value of your securities:

$6,000 (equity) / $12,000 (value of securities) = 0.50

Since your borrowed amount never changes, your equity percentage will rise or fall in tandem with the performance of your securities. 

What is a margin call?

A margin call occurs when the equity in your margin account falls below your broker’s minimum requirements. There are two types of margin calls:

  • Federal Regulation T Call: Occurs if you don’t provide enough initial equity during the purchase of the securities
  • Maintenance margin call: Occurs if your equity falls below the broker’s minimum threshold.

The first type of margin call, the Fed or Regulation T call, will only happen at the beginning of a trade. This call is triggered when investors don’t have enough equity in their account to meet the 50% initial margin requirement as set by FINRA, the Financial Industry Regulatory Authority.

The second, and more common, margin call is the maintenance margin call. This kind of call is issued by a broker when the investor’s equity falls below the maintenance margin requirement (the minimum balance, in either cash or securities, that you’re required to keep in the account). FINRA requires brokers to set their minimum margin levels no lower than 25%. However, many brokers set higher minimums of 30% or more.

The maintenance margin call usually happens because your investments have dropped in price – so far in price that your equity percentage falls below your broker’s minimum. 

In effect, your broker’s getting nervous: Your stock (or whatever asset you purchased) seems close to being worth less than the amount they loaned you to buy it. So they want you to put in more. 

It’d be like your mortgage lender discovering that, because of declining real estate values, your house had dropped in value – and so it demands that you immediately increase your monthly mortgage payments. 

Example of a margin call

Let’s return to the example of an investor who buys $12,000 of stocks using $6,000 of cash and $6,000 of margin. What would happen if the value of the securities dropped to $8,000? As the calculations below show, the investor’s equity percentage would drop to 25%:

$8,000 (value of securities) – $6,000 (borrowed amount) = $2,000 (equity)

$2,000 (equity) / $8,000 (value of securities) = 0.25 (equity percentage)

Now imagine that the broker requires a maintenance margin minimum of 30% and issues a margin call asking for a deposit of additional cash or securities to raise the equity back to the minimum. In this example, you’d need to add at least $400 of equity to reach the 30% minimum:

$8,000 (value of securities) x .30 (minimum equity percentage) = $2,400 (minimum equity)

$2,400 (minimum equity) – $2,000 (current equity) = $400 (additional funds needed)

What happens when you get a margin call?

There are a variety of ways to meet a margin call – or cover it, as the pros say. One of the simplest ways would be to just add cash to the margin account. In the margin call example above, the investor would need to add at least $400 of cash to meet the margin call.

Depending on your broker, you may also have the option of depositing other marginable securities into your account to satisfy a margin call. 

Finally, you could choose to sell some of your securities.

To calculate how many of your securities to sell, divide the margin call amount by the margin requirement. So, to continue our ongoing example, an investor with a 30% margin requirement may liquidate approximately $1,333 of securities to meet a $400 margin call ($400 / .30 = $1,333.33).

What happens if I can’t pay a margin call?

If your broker issues a margin call, you’ll want to act immediately to cover it. Usually, you’re given two to five days. 

If you don’t meet the call, your broker has the right to liquidate positions. Sell your assets, in other words (without giving you the opportunity to choose which are sold) to bring your account back up to its margin requirement. 

Having securities liquidated to cover a margin call can be devastating to an account. Once depreciated assets have been sold, they no longer have the opportunity to recover any of their value. The “on paper” losses become fully realized and “locked in.”

The financial takeaway

Margin calls are what make margin trading – borrowing money to buy securities – so dangerous.

Ways to avoid margin calls include keeping a sizable cash cushion in your margin account at all times. Regularly monitor your margin positions, to make sure they haven’t dropped in value to dangerous levels. 

Or if you want to guarantee that you’ll never face a margin call, you can forgo margin trading altogether – and fully pay for all your securities with cash.

Related Coverage in Investing:

Trading and investing are two approaches to playing the stock market that bring their own benefits and risks

How to diversify your portfolio to limit losses and guard against risk

Why invest in the stock market? Because it can be more dangerous not to

How to invest in stocks, even if you’re starting from scratch

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