Millions of people use margin debt on a daily basis. Traditionally what this means is the following. You buy 1000 shares of IBM and let's say you pay a $100 per share. You owe the brokerage firm $100,000. This is the market value of your account if it is the only item in your account. If you are a cash customer, you write a check for $100,000 by settlement date, and you own the 1000 shares of IBM free and clear of any encumbrances.

There is another way to go however. You can buy the $100,000 worth of IBM, and decide not to pay the full cost of the investment. Instead, you open a margin account with the brokerage firm, sign the appropriate documents and bingo, you can now buy that IBM by putting just 50% down, and the brokerage firm lends you the balance. They don't do it for free however. They charge you a fee on the borrowed funds. Depending upon how good a customer you are (frequency and size of trades), the interest rate charged will vary.

In a sense margin debt is somewhat similar to how you bought your house. When you bought your house, you probably did not fully pay for it. Instead, you put more than likely, 20% down, and borrowed the rest in the form of a mortgage from the bank. The difference is that in financial world, you must put 50% down to purchase a stock.

The Other Big Difference

If you buy stocks on margin, and the stocks decline in value, you could get called on the debt. Brokerage firms feel very comfortable lending money for margin accounts because they hold the securities as collateral. Brokerage firms begin to feel very uncomfortable when those stocks begin to go down in value. If the stocks should go down in value to the extent where the underlying securities are no longer supporting the value of the account, the account is deemed to be negative equity. This then becomes the brokerage firm's worst nightmare.

It's gets even better. Hedge funds are called hedge funds because when they go long certain positions, they are supposed to be short other positions to OFFSET the long positions. Hedge funds therefore make their money on VOLATILITY. The laws allow hedge funds to borrow (leverage) their capital base. This means instead of putting down 50% on an investment's market value, they will use as much as six times leverage. We have seen hedge funds go to ten times leverage. Recently, we have also seen hedge funds crash and burn.

This is what you need to know. Years ago, when I was with the largest investment firm in the world, we did an internal study. The study showed that the average life expectancy of a margin account before getting a margin call (the need to deposit more cash into an account) was 19 months. This means in our opinion that if you are a margin player, you will at some point get called on the account.