Investors who want to make it big from trading don't always have the funds to back themselves up front. This leads them to invest on someone else's dime, like against their own investment portfolios. Investing on margin is risky, and many trading platforms don't allow it. But for those that do, Americans are making the most of it.
Now, margin debt has reached a new record, totaling $722.1 billion. This screams market euphoria, which could mean trouble for heavily indebted investors.
What is the FINRA margin debt?
The Financial Regulatory Authority (FINRA) is a not-for-profit entity and self-regulatory organization that keeps track of all the FINRA member firms who carry margin accounts, or accounts that allow investors to trade on margin. These member firms must provide FINRA with all debit balances in securities margin accounts, plus all free credit balances in both cash accounts and securities margin accounts.
Margin debt levels for 2020 have reached new heights
Margin debt hit a record $722bn last month. I am fully invested and remain bullish on the low interest rate environment, but not sure how people sleep at night with so much leverage— Cornelius Capital (@10xMOIC) December 27, 2020
Based on FINRA's 2020 data, investors have borrowed a total of $722.1 billion against their investment portfolio margin accounts through the month of November. This is more investment debt than ever before, with the previous record from May 2018 sitting at $668.9 billion.
Margin debt growth has compounded at a rapid rate since the start of the COVID-19 pandemic. In fact, the value has grown by 28 percent since Nov. 2019, and it has grown another 10 percent since Oct. 2020.
This debt consists of trading activities like options, day trading, short sales, and other risky plays. In particular, options trading is one of the more complex aspects of the stock market, and uneducated traders can get into serious trouble. Regardless, options contracts have surged 48 percent in 2020.
Experts suggest that this market euphoria can be traced back to eagerness over the COVID-19 vaccine, which has recently begun circulating to preferred patients (like political leaders and healthcare workers, for example). Plus, the second stimulus package has officially made its way through the legislature—with a potential addendum to increase the size of individual stimulus checks to $2,000 instead of the previously approved $600.
Does high margin debt mean an imminent market crash?
Historically, high margin debt rates come before concentrated periods of volatility in the stock market. We saw this both in 2000 after the dot-com bubble burst and in 2008 after the start of the Great Recession.
Prior to both of these events, market euphoria was on the up and up. People were trading willfully on margin, and the results were devastating for many invested Americans—especially those with a slimmer time horizon (like older people and those who traded liquidity for securities).
While high margin debt doesn't necessarily equate to a forthcoming market crash, it's not a good sign. Traders who are using risky tools on margin are only adding fuel to an already blazing fire. Their fate isn't sealed, but they're not in nearly as much control as they think they are.