Margin Trading Tutorial
The Risks
It should be clear by now that margin accounts are risky and not for all investors. Leverage is a
double-edged sword, amplifying losses and gains to the same degree. In fact, one of the definitions of
risk is the degree that an asset swings in price. Because leverage amplifies these swings then, by
definition, it increases the risk of your portfolio.
Returning to our example of exaggerated profits, say that instead of rocketing up 25%, our shares
fell 25%. Now your investment would be worth $15,000 (200 shares x $75). You sell the stock, pay back
your broker the $10,000, and end up with $5,000. That's a 50% loss, plus commissions and interest, which
otherwise would have been a loss of only 25%.
Think a 50% loss is bad? It can get much worse. Buying on margin is the only stock-based investment
where you stand to lose more money than you invested. A dive of 50% or more will cause you to lose more
than 100%, with interest and commissions on top of that.
In a cash account, there is always a chance that the stock will rebound. If the fundamentals of a company
don't change, you may want to hold on for the recovery. And, if it's any consolation, your losses are paper losses
until you sell. But as you'll recall, in a margin account your broker can sell off your securities if the stock price
dives. This means that your losses are locked in and you won't be able to participate in any future rebounds
that may take place.
If you are new to investing, we strongly recommend that you stay away from margin. Even if you feel ready
for margin trading, remember that you don't have to borrow the whole 50%. Whatever you do, only invest in
margin with your risk capital - that is, money you can afford to lose.