Why Buying Stocks on Margin is Dangerous

by News Guy on January 21, 2013

There are never any guarantees when it comes to playing the stock market, however; there are some methods of trading that are riskier than others. Buying on margin can be a dangerous game and should only be attempted by the expert stock trader. A person who uses this method to play the stock market, could end up owing more their broker a great deal of money.

Many people are really unsure of how buying on a margin works. To understand the risk, a person must know how this type of trading works. By definition, a margin is making an investment on money that is a person doesn’t have, or a borrowed amount. For instance, if a individual has ten thousand dollars in their broker account, they can borrow money against their existing stocks. By borrowing this money, this will allow them to purchase even more stocks than their current monies would allow. This is what is known as trading on a margin and it is a very risky move for those with little capitol or assets. If someone wants to become more aggressive with their stock investments, they can use this option. While this sounds like financing stock purchases in a way, there are many draw backs to this kind of transaction that need to be explored before investing.

The broker makes the decision on who is eligible for this type of trade, and they base it on the associated risks. They allow qualified traders to purchase securities. Securities on a margin are simply borrowing money on assets that are in a trader’s portfolio. The broker will give the trader a fixed interest rate and the rates are whatever that broker chooses. The more a person borrows the less the interest rate will be. For instance, a person who borrows $100,000 dollars will pay a lower interest rate than someone who is borrowing $10,000.

Each broker will have their own rules for their margin maintenance requirements and the management of shares. The broker will require the investor to keep a certain amount of equity on their stock portfolio to secure this kind of arrangement. The more risk the house is at losing money on the broker, the more money they will want in maintenance requirement. Every house is different and rates can vary from 30 to 50 percent.

It becomes complex when dealing with margins because the securities that are in a person’s account are all held as collateral for the outstanding margin amount. Each house broker will have their own requirements in these types of transactions and it will be varied. The broker has the option to sell a person’s investments if they fail to meet the obligations set forth in the original margin agreement. They will want to restore the equity to the required levels before they will allow the margin relationship to be reestablished.

Because of the complex structure, and borrowing more than what a person actually has in tangible investments, trading on a margin is very risky. A person can realistically lose more than what they have. If an investment doesn’t go well, the person who lost will be responsible for the outstanding amount that is owed to the house. If a bad financial deal wipes out an investment account, then the person still owes the difference to the broker. Because of the risk involved with the broker, they can charge an interest rate and change it at any time.

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