5) Margin Trading: The Risks

In the same way that leverage can increase profit, it can also increase losses just as much. Margin trading involves a lot of risk. Not only will you be “gambling” with your own money, but on borrowed money as well. It is important to note that buying on margin is the only stock-based investment where you could lose more than you invested.

Remember the example of John in the previous section of this tutorial? Let us say that Company X’s price of shares went down 30% instead. The investment John made on Company X would now be worth $21,000 (300 x $70), a huge drop. John decides to unload the stocks, pay back his broker the $15,000, and only has $6,000 left from his investment. It’s more than a $50 loss. Again, we haven’t taken into account the commissions and interest. If you add these up, the loss would have been greater.

Why would John immediately sell the stocks after its price dropped, instead of holding on to it until the price increased? Remember that in a margin account the broker can sell off your securities if you go below the maintenance margin. It would not be too wise to put in more funds considering the losses. The interest charges would have gone up while you wait for a price rebound and that could take a while. In the meantime, you could possibly be adding more to your losses.

Compare this to a cash account, the losses will only be paper losses until you sell the stock. Plus there is always that chance that the stock prices will rebound so you may want to hold on and wait for the recovery.

Clearly, margin trading is not suitable for beginners. If you are new to investing, we suggest that you stay away from it. If you think that you are ready to take a risk on margin, you don’t have to borrow the whole 50%, and only invest on what you can afford to lose (risk capital).