Risks Associated with Margin Trading

Table of Contents
Chapter 1: What is Margin Trading
Chapter 2: Margin Trading Terminology
Chapter 3: When to Use Margin Trading
Chapter 4: Risks Associated with Margin Trading

Navigate This Page
Chapter 4: Risks Associated with Margin Trading

Chapter 4: Risks Associated with Margin Trading

Margin trading can sometimes wipe out your investment when stock prices drop. The broker’s loan gives him a certain measure of control over your investment strategy and this can prove disastrous when the stock declines.

If the value in your account drops below the maintenance margin, the broker makes a margin call. You either sell your stocks and convert them to cash to bring the maintenance margin up to the minimum level or deposit more funds from elsewhere.

A broker can also simply sell your collateral stocks without waiting for you to rectify your maintenance margin position. This is a huge risk you have to face by giving the broker, as your lender, this degree of control over your investment. Check your margin agreement to see if the broker has the right to do this.

However, the biggest risk that you take when you trade on margin is amplification of losses. Let’s look at our example again to see how a decline in stock prices can affect an investor. What if the Olympic committee decides in favor of Nike after a batch of faulty shoes are delivered to top athletes from Kramer’s and the company’s stock price plummets to $10 a share?

Scenario 1: You Used Your Own Funds

Your investment is now worth 25 shares x $10= $250, which is a dismal 50% of your original investment of $500. If you sell the shares now, you would lose $250. However, you don’t have to sell your shares now. You can wait to see if Kramer’s can regain its original $20 a share level when you can at least break even. You are still in control of the situation, though it is very unlikely that you’ll make a profit on the investment.

Scenario 2: You Used $500 from Your Broker in Addition to Your Own $500

After the decline, your investment is worth 50 shares x $10 = $500. But you still have to repay the broker his $500. The balance in your account is less than the minimum requirement and your broker will issue a margin call. You now have to pay up the shortfall from funds outside the investment or sell the stocks to make up for the shortfall. If you are forced to sell the shares, your own investment of $500 will be completely wiped out.

If the stock price falls further before you sell the shares, you would end up paying more than you originally invested in Kramer’s Shoes. And this scenario is not unrealistic at all. It is seen time and time again.

Every time there is a major crash in the stock market, thousands of investors see their investments being completely wiped out. It can be an extremely stressful affair as you try your best to meet your margin requirements and the stock price falls further, making the situation even worse.

Buying on margin is an investment strategy fraught with risks but experienced investors still use margins because of the substantial gains they can make if prices go up. Over the years, the margin buying process has become more structured and well regulated.

Earlier, brokers were often left with huge unrecoverable losses because minimum maintenance requirements were at best inadequate. Brokers have now become more cautious and set stricter minimum requirements for margin accounts.

This benefits not just the brokers but also the investors because the higher minimum requirement forces more caution when investing. The stake of the investor is increased, making him more accountable and responsible when making investment decisions.

Margin buying can be both a route to huge gains and a recipe for devastating losses. Experience in the markets and exercising caution are key to success when you are trading on margin.