Category Archives: margin calls


After every stock market crash we search for the causes and change rules and regulations to prevent future recurrences. Politicians are not well suited for the task. It is unlikely that the current rules and regulations will prevent a future crash because they fail to prevent or adequately limit use of practices which exacerbate market declines such as short selling, stop loss orders, chart theory and excessive margin buying which leads to margin liquidations in declining markets. Managers of many large pools of capital understand the effects of such practices and execute trades timed to further enhance extreme market declines so that they can then become buyers after the precipitous decline.

The talking heads on financial news networks have speculated lately on whether a 20% stock market decline like the one that occurred on October 19,1989 might occur again. They discuss the fact that a 600 point decline in the Dow is currently only about a 2% decline and that a 20% decline would amount to more than 5000 points in the Dow. They often talk about the differences in the US economy between 1989 and now, the possibility of a recession, the strength of corporate earnings and balance sheets, the trade war with China, tariffs, the effects of negative European interest rates, the rate of inflation and the Feds current stance on interest rates and its balance sheet. However, I haven’t heard them talk recently of governmental regulations or controls in place to prevent the recurrence of a 1989 type decline. The safety net value of current regulations and controls in place were about to be tested last year until the Fed reversed its course on interest rates after raising interest rates too fast and projecting ridiculously stupid further interest rate increases and balance sheet reductions. Has the Fed already forgotten the result of its successful policies which enabled our economy to escape from the Great Recession. Does the Fed understand that excessive stock market declines can lead not only to a recession, but as in the 1930’s to a depression? Fed chief Powell stupidly talks of patience when he should have admitted his error in adopting overly restrictive Fed policy decisions. 

Most of us learned from old western movies that a rancher who wishes to avoid a stampede of his horses or cattle builds secure fences or takes precautionary measures when moving his herd. Our current securities regulations and controls which are designed to stem an out of control decline were influenced by investment bankers seeking to maximize their profits by encouraging speculative practices in disregard of stock market stability. Brokers profit from charging high rates of margin interest and charging short sellers for borrowed stock. Speculators often profit in declining markets from short sales at declining prices made possible by the elimination of the uptick rule. A combination of factors acting in concert, including short selling at declining prices,  stop-loss order liquidations, margin calls, tax selling, reaching chart theory sell points and panic, cause stock price declines to be exaggerated.

Now is the time to take action to change the government regulations and controls of the securities markets to greatly reduce the probability of a crash. The Fed and the SEC should work together. Here is what I propose:

  1. The SEC should immediately reinstate the uptick rule and prevent way to avoid it. It was lunacy to remove it.
  2. The SEC should ban all new short selling when  any of the Dow, S&P or the NASDAQ averages (the “leading market averages”) have declined more that 20% from their 6 month highs; and continue the ban until all such averages have recovered at least 10% from their low point after the ban is put in place.
  3. The Fed should limit the risk of margin liquidations by changing margin requirements to provide that aggregate initial margin in an account shall be reduced to 40% during each 30 day period after which any of the leading market averages has hit a 12 month high.
  4. The SEC should change the way stop loss orders operate. Make them become good until canceled limit orders and not market orders when the stop loss point is reached. This will reduce the avalanche aspects of sales at declining market prices and discourage misplaced reliance on the protection of stop loss orders.
  5. Try to reduce dumping of large numbers of shares by active traders by charging a small fee on the dollar amount of all sales of securities held less than 5 years.

The Feds goal of full employment is negatively impacted by stock market declines. A reduction in the wealth of investors negatively impacts their spending. The Fed should stop talking foolishly about “patience” and clarify that it intends to reduce interest rates and engage in QE whenever stock prices decline significantly.


The Fed Should Have Raised The Initial Margin Requirements, Not Interest Rates

Investors who utilize maximum margin to leverage their equity purchases in rising stock markets often greatly increase their gains. The problem is that they also increase their risk of loss. Investors who keep utilizing their buying power resulting from price increases to maximize their margin debt are like casino gamblers who never take any chips off the table. No-one should expect a favorable run to continue forever. Rising stock market averages and prices of the common stock of even the most successful entities tend to overshoot their fair value and eventually incur corrections.

Present margin rules as set by the Fed require initial margin of 50% and maintenance margin requirements of 25%. The maintenance requirement only comes into play if the value of a portfolio declines. For example, assume you have $10,000 to invest. You could buy $20,000 of stock on margin. “The broker lends you the other $10,000. If the stock triples and goes up in value to $60,000 giving you an equity of $50,000  you can borrow an additional $40,000 and purchase additional securities of the same or a different entity. You  have maximized your use of margin. Had you not bought on margin your investment would be worth $30,000. Now suppose the portfolio doubles again. Your initial investment is now worth $150,000 ($200,000 of equity minus $50,000 of debt) versus $60,000 of equity had you not utilized margin. Suppose you borrow an additional $100,000 to purchase additional securities leaving you with $300,000 of securities with maximum margin debt of $150,000.

Now, let’s assume the stock market goes into correction and your securities decline by 20%. They are now worth $240,000, leaving you with $90,000 in equity and $150,000 in debt. To meet the 25% maintenance requirement you must have a total equity of  $187,500 (25% above the debt of $150,000). Suppose the decline from the top reaches 40% leaving you with an aggregate value of $180,000 or a net equity of $30,000. This is below the 25% maintenance requirement and you will be required to either add cash or sell securities to reduce the debt to meet the maintenance requirement. After a meteoric rise from $10,000 to $150,000 the value of your account is back to $30,000. Had you not bought on margin your hypothetical investment would be worth $36,000 ($60,000 less $24,000). Had you not borrowed the last $100,000, Your investment would be worth $$70,000 ($120,000 minus $50,000). You would not have received a margin call.

Every investment situation is different. The above example is an attempt to examine the risks and potential advantages and disadvantages of use of margin leverage. In periods of “irrational exuberance” the risk of loss increases. The Fed can reduce margin risk by increasing the initial margin requirement thereby limiting the ability to increase margin debt if it perceives a significant risk of a market decline.

The Fed should be cautious of margin risk. Sales to meet margin requirements whether by choice or by requirement can exaggerate a decline in a falling stock market. Such sales, coupled with the inept uptick rule adopted by the SEC that permits short sellers to initiate a market decline  and the potential waterfall effect of  stop loss orders that might in a declining stock market be executed electronically at declining prices, can be leading contributors to a stock market crash.

The Fed is raising the wrong rate. As described in my previous post it should not be raising interest rates which both cause inflation and slow the economy leading to stagflation or a recession. It should have been concerned about controlling individual investor and market risk caused by excessive margin debt as market averages and p/e ratios rose to new highs. Hopefully, it will have that opportunity again in the future.






The Twitter Stock Price Roller Coaster

In the short time period since the Twitter IPO its stock price has performed as if it was riding a roller coaster.  Various factors have contributed to its meteoric rise to a peak, followed by a rapid decline. Market factors unrelated to the fair market value of Twitter shares have influenced the price movement. Prior to the Twitter offering, IPOs were in a state of great demand (which occurs from time-to-time) with investors of most IPOs being allocated less shares than requested. Many investors were purchasing  the unallocated portion of their subscription as soon as the IPO commenced trading. The Twitter offering was highly glamorized by the financial press. Twitter shares like those of many other IPOs immediately skyrocketed in price. Twitter has many loyal users who were unable to obtain an allotment on the IPO and they and other investors for various reasons elected to buy the shares in the after market. Chart theorists added fuel to the fire as they determined buy points as the Twitter stock price rose and gathered momentum. As the stock price rose far above the IPO price it attracted short sellers. However, as ofter occurs when short sellers sell into a rapidly rising market, they get squeezed and panic, one-at -a-time, and cover their shorts at ever increasing prices, thereby driving the stock price higher. 

When the price of Twitter shares peaked and started to decline, various factors, acting in a manner similar to the way that gravity effects a roller coaster car, precipitated the decline. Some analysts withdrew their support based upon market capitalization and recommended sale . Stop loss orders, which have become fashionable and which were placed at various levels during the share price increase, began to be executed at declining prices, creating selling pressure. Chart theorists interpreted sell signals. Short sellers, who follow the analyst reports, know about the existence of stop loss orders and understand chart theory, exacerbated the decline by selling short at declining prices. As the stock declined, margin calls and tax loss considerations came into play and some unsophisticated stockholders sold in panic. 

Like a roller coaster the ride will stop at the bottom. If Twitter can generate revenues and profitability from its large number of followers, its shares will begin to rise again. If, as I expect, the rise occurs, the SEC should conduct an investigation as to when every short sale took place to try to determine the role of short selling in exaggerating stock market declines.

Short Selling Does Not Promote Pricing Efficiency

Only fools, who do not understand the interplay of short selling with  chart theory, stop-loss orders, margin calls, and panic selling in market downturns, think that short selling is a price discovery mechanism that leads to pricing efficiencies. In fact, it generally exaggerates price swings. Short selling is often used as a manipulative device and it should be banned or carefully regulated. The up-tick rule should be reinstated immediately. In addition, all short selling in a security should be banned when its price has declined substantially from its 52 week high.

You should read the short chapter entitled “Short Selling and Stock Market Manipulation” in my book entitled “Perpetuating American Greatness After The Fiscal Cliff”. My earlier book entitled “Homeland Security And Economic Prosperity” written after 9/11 and the bursting of the .com bubble, but while the up-tick rule was still in effect, proposed strengthening the up-tick rule to prevent bear market raids by short sellers. Subsequently, the SEC ignored the bear raids in 2007 and 2008 and ignorantly eliminated the up-tick rule. My original paper on the subject was written while I was a third year law school student in 1963. Since then SEC regulation of bear raids has gotten worse, not better.

Beware Of The Role Of Short Selling And Stop Loss Orders In The Current Market Decline

For months we listened to investment experts on financial news programs advise investors to protect their positions against a market correction by using stop loss orders. As stock prices rose investors, who heeded the advice of these experts, placed stop loss orders at increasing price levels. As a result an inverse ladder of stop loss orders was created. When international currency issues and other factors set off a moderate market downturn some of the highest stop loss orders were automatically converted into sell orders and the market decline accelerated. Short sellers who have been on the side lines were able to accelerate the decline by selling short on downticks. They know the price on stock charts that chartists interpret as a sell point and begin to sell short on downticks in an attempt to encourage sales by chartists, the execution of stop loss orders and panic by fearful investors. The combination of stop loss orders, chart theory, short selling on downticks and ultimately panic and margin calls may set off a stampede leading to further market declines. Domestic and international economic growth are important to stock market activity, but the above described technical factors have a significant impact during a stock market market decline that may, because of the wealth effect and fear, lead to a downturn in economic activity.