1. Margin Trading: Introduction
  2. Margin Trading: What Is Buying On Margin?
  3. Margin Trading: The Dreaded Margin Call
  4. Margin Trading: The Advantages
  5. Margin Trading: The Risks
  6. Margin Trading: Managing Risks
  7. Margin Trading: Conclusion

The risks of margin trading include...

 

Risk of amplified losses:

As mentioned earlier, margin trading can amplify gains as well as losses. The example below shows how it is possible to lose more than 100% of your investment in margin trading. A loss of $10,425 on a $10,000 investment means that in addition to losing his or her entire $10,000 investment, the trader is also on the hook to the brokerage for an additional $425. If the stock plunges to zero rather than $50 after six months, the total loss would be $20,425 and the ROI -204.25%. In this scenario, the trader has not only lost the full $10,000 investment, but also has to repay the brokerage the margin loan of $10,000 plus the interest charge of $425. Note that a debt obligation to a broker is as binding as a debt obligation to any bank or financial institution, and must be repaid in full. (Related: Risks And Rewards Of Margin Investing)

Margin call

As discussed earlier, if the securities bought on margin abruptly have a sharp decline (or in the case of a short sale, if the shorted security spikes in price), the investor is faced with a margin call and may have to come up with a substantial amount of cash or marginable stock at short notice. (Related: Why is purchasing stocks on margin considered more risky than traditional investing?)

Forced liquidation

If the investor cannot meet a margin call, the brokerage can and will sell the margined securities without further notice. In a plunging market, forced liquidation this may result in the investor’s position being sold at the worst possible time and generating a large loss. To add insult to injury, if the margined securities eventually turn around and end up being back in the black, the investor would have been needlessly “whipsawed.”

Interest charges and rate risk

Margin accounts have a fairly high rate of interest. The interest cost on margin debt can add up over time and significantly erode the gains made on margined securities. In addition, interest rates on margin debt are not fixed but can fluctuate during the time that an investor has margin debt. In a rising interest rate environment, the interest rate on margin loans will head higher, adding to the interest burden for investors engaged in margin trading.

Extra vigilance in account / portfolio monitoring

Margin trading requires an investor to be extra vigilant in monitoring the margin account or portfolio, to ensure that the margin does not fall below the required level. This can be especially stressful during periods of enhanced market volatility.

 


Margin Trading: Managing Risks
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