Margin trading allows investors to borrow money from their broker to purchase more securities than they could with their own cash, amplifying both potential gains and losses. While margin trading can increase an investor’s purchasing power and provide opportunities for significant returns, it also exposes them to substantial risks. Excessive use of margin trading magnifies these risks, potentially leading to devastating financial consequences.

What Are Some of the Key Risks of Margin Trading?

1. Amplified Losses

• How it works: When using margin, an investor can buy more securities than they could with just their available cash. If the value of the securities increases, the investor benefits from gains on the entire investment, including the borrowed portion. However, if the value of the securities decreases, losses are magnified.
• Risk: If the stock price falls, the losses on the entire position (including the borrowed funds) accumulate quickly. Excessive use of margin can lead to losses that exceed the initial investment, as an investor is responsible for repaying the borrowed amount regardless of the performance of the investment.

2. Margin Calls

• How it works: A margin call occurs when the value of the securities in a margin account falls below a certain threshold, called the maintenance margin. When this happens, the brokerage firm requires the investor to either deposit more funds or sell securities to bring the account back within compliance.
• Risk: If an investor receives a margin call and cannot meet the requirements (by adding cash or securities), the brokerage firm has the right to sell the investor’s assets to cover the loan. This forced sale can occur at a time when market prices are low, resulting in the realization of significant losses. Investors often have little control over the timing of these sales, which may occur before the market has a chance to recover.

3. Interest on Borrowed Funds

• How it works: When trading on margin, the borrowed funds are subject to interest charges. The broker charges interest on the amount borrowed, and these costs can accumulate, especially if the margin loan is held for an extended period.
• Risk: If the returns on the investment are not sufficient to cover both the principal and the interest, the investor may end up losing money even if the value of the securities increases slightly. Excessive margin trading can lead to a situation where interest costs pile up, eroding profits or deepening losses.

4. Market Volatility

• How it works: In volatile markets, stock prices can experience rapid and significant swings. Investors using margin are more exposed to the effects of these price fluctuations, as their positions are larger due to the borrowed funds.
• Risk: High volatility increases the likelihood of margin calls. A sudden downturn in the market can quickly deplete the equity in a margin account, forcing the investor to meet a margin call or face liquidation. This is especially dangerous during periods of sharp declines or market corrections.

5. Overleveraging

• How it works: Leverage in margin trading refers to the use of borrowed funds to increase the size of an investment. Overleveraging occurs when an investor borrows excessively, significantly increasing their exposure to risk.
• Risk: Overleveraging can lead to catastrophic losses, as a small adverse movement in the market can wipe out an investor’s equity. In some cases, losses can exceed the amount initially invested, leaving the investor with a negative balance and a significant debt to the broker. Overleveraged positions are especially vulnerable in highly volatile markets, where sudden shifts in price can trigger rapid losses.

6. Lack of Control Over Liquidation

• How it works: In a margin account, if the value of the securities falls too low, the broker has the right to sell some or all of the securities in the account to cover the margin loan. The investor has no say in when or which securities are sold.
• Risk: Investors could be forced to sell at inopportune times, locking in losses that might otherwise have been temporary. If the market recovers after the forced sale, the investor misses out on potential gains. Furthermore, brokers can sell securities without prior notice to the investor, reducing the ability to make strategic decisions during market downturns.

7. Psychological Pressure

• How it works: Trading on margin can lead to emotional and psychological stress, particularly during periods of market volatility. The amplified risks associated with margin trading can cause investors to make impulsive or irrational decisions.
• Risk: Fear of margin calls or mounting losses can lead to panic selling, poor decision-making, or taking on even greater risks in an attempt to recover losses. This psychological pressure can lead to a downward spiral, where an investor makes increasingly risky trades in an effort to turn around a losing position.

8. Potential for Unlimited Losses in Certain Trades

• How it works: Some types of trades, such as short selling, involve borrowing securities and selling them with the expectation that their price will decline. When shorting on margin, the investor borrows shares to sell with the intention of buying them back at a lower price.
• Risk: Unlike buying securities, where the maximum loss is limited to the amount invested, short selling (especially on margin) exposes the investor to unlimited losses. If the stock price rises instead of falls, the investor is required to buy back the stock at the higher price. Excessive margin in short trades can lead to extreme losses, as stock prices can rise indefinitely.

9. Limited Time to Recover from Losses

• How it works: In traditional investing, investors have time to ride out market volatility and wait for their investments to recover from temporary dips. However, margin trading introduces an urgency, especially when margin calls occur.
• Risk: Margin traders often don’t have the luxury of waiting for a market rebound. A significant drop in stock prices may force the investor to sell quickly, often locking in losses that could have been avoided if they had been able to hold onto their investments for a longer period.

10. Regulatory and Broker Limitations

• How it works: Regulatory bodies like the Financial Industry Regulatory Authority (FINRA) set minimum margin requirements that investors must maintain in their margin accounts. Brokers may also impose stricter limits on margin usage.
• Risk: These limitations can restrict the investor’s flexibility in managing their portfolio. If an investor approaches the regulatory or broker-imposed margin limits, they may be required to reduce their exposure or deposit additional funds, potentially resulting in forced sales or other actions that are not aligned with their long-term strategy.

If you lost money due to improper or excessive margin trading, or in Securities backed loans, you may be able to recoup your losses through securities arbitration.

Israels & Neuman PLC has knowledgeable securities attorneys that represent investors who have suffered losses due to the actions of brokers, financial representatives, broker-dealers, and financial institutions.  We have represented numerous victims of excessive or improper margin trading and unsuitable Securities backed Loans in FINRA arbitration proceedings throughout the country.  We represent clients in all 50 states.

All of our financial arbitration cases are taken on a contingent basis, meaning that we do not get paid unless we recover compensation for you.