5 Major Problems with Buying Stocks on Margin

This apparent offer to pump up as much profit as possible in the stock market by buying stocks on margin sends many investors a little giddy because no one would ever be unwilling to use his existing capital to buy more shares than he might manage with cash. However, buying on margin is fraught with several risks. And then there’s always the other side of the coin-not the possibility of a sensational gain, but the possibility of a catastrophic loss. End. This article explores the five biggest problems related to buying on margin for stocks, using real life examples to demonstrate exactly how margin trading can take down a scam.


We will uncover and deconstruct five significant issues with margin trading explaining precisely how each of them can take a profitable opportunity and turn it into a financial disaster. By the end of this chapter you will be better armed to recognize the pitfalls of margin trading and understand how to avoid them.


What Is Buying on Margin?


Before going into the associated risks, let’s first describe what it means to buy on margin before going into the risks associated with it. Buying on margin is essentially using borrowed money from your brokerage firm to pay for stocks. Normally, in margin trading, you pay a percentage of the total amount in cash and the brokerage firm advances the remaining amount. The stock you purchased is almost treated as a collateral for a loan. In that sense, having more shares than what you could buy using the cash paid by you will increase the return if the stock price rises. On the other hand, stock price drops magnify losses and may even lead to grave financial loss.

1. You are highly exposed to losing much more than you principal investment.


The Problem

The most obvious weakness of buying on margin is that you place yourself in a higher risk of losing more money than you initially invested. This occurs because margins magnify losses as well as gains. When the price of the stock declines, in addition to the loss of some of the value of your investment, you lose some additional money, which is money you have borrowed from the brokerage.


Why It Happens
This implies that with a decrease in the value of the stock portfolio, the margin loan balance will not be affected. In other words, the amount that you are liable to pay back does not change with the price drop of any given stock. The worst case could be that your losses have exceeded your original investment, such that you stand to owe money to the brokerage firm.

Case Study

An example would be a case of the retail investor. For instance, Tom had loaned money on a margin to invest in tech stocks worth $100,000 at the beginning of 2022. By the last part of the year when the market was trending downwards, his account showed 40%. His $100,000 investment was now worth $60,000 and he owed $50,000 in brokerage. Tom had swallowed the cost of a $10,000 margin loan after all his money had been wiped off. This is the dark side of margin trading—losses can quickly spin out of control.

2. Margin Calls Can Force You to Sell at a Loss


The Problem

A margin call is probably one of the most notorious hazards associated with purchasing on margin. In exchange for making more money available on your behalf through buying stocks on margin, if you sell any of your investments for less than this benchmark, your brokerage will either send a margin call; that is, they will require you to add more cash to your account, or they will begin to sell assets to bring your brokerage account back up to the minimum margin level.

Why This Happens

Brokerages make you carry a minimum equity amount in your margin account, known as the “maintenance margin.” When your stock price falls too low, you no longer meet this requirement. The brokerage will call a margin in order for the equity balance to rise to that maintenance level, and you will have to deposit more or sell part of what you possess.

Case Study

Sarah used a $100,000 margin loan when she bought her stock. She also had $200,000 in her stock portfolio. When there was an unexpected correction in the stock market, her whole stock portfolio decreased to only $130,000. Her brokerage firm issued a margin call asking her to inject $20,000 to meet the margin requirement. Unfortunately, Sarah failed to generate the sum of money she needed and sold her shares at a loss that sealed her financial disaster.

3. Interest payments make up the investment cost.

The Problem

You are really just lending money to your broker whenever you invest in the margin, and just as with any other loan, you pay interest on it. These interest payments diminish your returns and are making it hard to realize positive returns.

Why It Happens

A brokerage firm charges interest on the money it has lent, and the rate of interest will be different depending upon the firm and the quantum of borrowing. If the stocks you purchased on margin do not pay off very well or generate small returns, the interest may run higher than your gains, and you incur a net loss.

Case Study

For instance, David invests $80,000 in stocks with $40,000 cash and borrows $40,000 on margin. His investments earned but a fraction more than 5% in a year; meanwhile, interest on the margin loan paid at 8% accrued. David ended the year in loss-even though, as we will see, his stocks rose in value. This is an illustration of how margin interest can creep into investments and turn a potentially profitable business into a losing one.

4. Volatility in the market results in higher losses

The Problem

Stocks by their nature, are volatile and especially buying on a margin platform increases the risk. In a volatile market, such an otherwise minor price fall can go rather high in losses while one is buying on margin.

Why It Happens

When one goes out to buy stocks using the margin facilities, then they don’t own the entire extent of stocks for which they have issued the purchase request. One acquires an enhanced exposure and the amount bought is not the entirely owned portion but rather one with a pending intention of paying out the balance to buy more stocks. This is particularly dangerous in periods of high volatility – where prices can short-term inflate and plummet dramatically.

Case in point

Mark owns a small business; he bought airline company shares on margin at the peak levels of volatility seen during the pandemic period in 2020. He was hoping the price would rebound quickly. Instead, it never rebounded and kept falling, and his portfolio shed 30% of its value in days. A margin call forced Mark to sell his shares at a loss. Had he purchased the shares outright without margin, he might have been pliable enough to hold them and wait for a recovery.


5. Psychological pressure to get out too soon from positions.

There’s a problem

when buying on margin, psychological stress can cloud the calculus of good investment decisions.
Fear that another margin call will come or losses can be counted again makes you sell too early.

Why it happens

The pressure of always paying for the brokerage also cloudy logic. Investors overreact because sometimes they want to avoid further losses and, worse, more margin calls. They may forgo the eventual upside potential when the stock price does recover.

Case study

Investor On margin, Emily bought shares of an explosively growing tech company. She sold out after the stock’s short-term price collapse, panicking about a margin call. Weeks later, the stock rebounded sharply, but Emily had locked out and lost money on the trade. Had she given in to margin trading pressure, she would have sold the stock, but with the rebounding price resulting from that, she would have lost by the trade.


How to Avoid the Risks of Margin Trading

Margin trading is full of potential risks but one can, however use some strategies that would help regulate those pitfalls:

  1. Limit Your Use of Margin You should use margins for only a small percentage of your portfolio. It will then limit your exposure to potentially huge losses and reduce the chances of a margin call.
  2. Set Stop-Loss Orders An application for stop-for-loss usually allows the automatic sale of stocks once they are down to a certain price. Contain Losses and No Margin Calls with Stop-Loss Orders.
  3. Diversify your portfolio Invest your money in different sectors and classes of assets. Diversification reduced the overall risk in your portfolio, especially when using margin.
  4. Know your margin requirements Know the margin rules of your brokerage inside out. Always be aware of your equity level to avoid surprise margin calls.
  5. Maintain cash reserves Build up enough cash reserve to cover margin calls, if they come along. It gives you the flexibility not to sell at a loss.

Conclusion

Buying shares on the margin has merits and demerits. Buying shares on margin allows a prospect of enhancing the returns but also increases the risk associated with returns. Margin trading dilemmas include the risk of losing more than your initial investment, the risk of margin calls, the weight of interest payments, and the psychological pressure.

As demonstrated by the case studies, even the most sophisticated investors are prone to such risks. And, at the end of it all, over-weighting your decision to margin is always worth avoiding. A solid financial plan and knowledge of your tolerance levels for risk are required before applying the investments. You avoid all common pitfalls and make the proper decisions for taking care of your finances.

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