Top Investing Mistakes – Using Too Much Leverage to Trade

One beauty of the investing market is the ability to borrow money from your broker at a reasonable rate and trade stocks with the money you normally wouldn’t have.  For example, if you put $30,000 into a “margin account” with broker X, you actually may gain the ability to trade $50,000 worth of stocks by borrowing money from the broker and pay certain interests.

While margin accounts provide investors with an additional boost to their investing power and may help profit much more than otherwise, margins can also be extremely dangerous and can put investors at a disadvantage.

The real danger is not necessary the fact that you’re borrowing money and paying interests on it (though it’s never good to have debt with stocks), the true danger sneaks in when you borrow too much, to a point where you received a margin call frequently.

Margin call, also known as a maintenance call, occurs when a broker demands an investor using a margin account to deposit additional money or sell the securities owned so that the investor can maintain a certain amount of margin.  In other words, investor’s stock value depreciated to a point where the broker is no longer willing to lend him the same amount of money it did previously.

For example, if your portfolio is worth $30,000, the broker may be willing to lend you $20,000, totaling your “buying power” to $50,000.  However, what would you do if you were the broker, and this same investor’s portfolio is now worth $5,000 because his stocks depreciated in value so much?  Will you still be willing to lend him $20,000 (4x his “liquidity”)?  Probably not.

This is the big danger behind the margin accounts.  While it is nice when you borrow money to make more money, it can be devastating to your account balance if you’re borrowing too much and the stocks you own are depreciating in value quickly.  When you are forced into a margin call, you may not have the additional cash on hand to off-set the depreciating stocks.  If you don’t have the cash, you are forced to sell the stocks at a non-reasonable price.  If you had simply avoided borrowing too much money, it may have allowed you to hold onto the stocks longer until it recovered.

Imagine buying a stock with borrowed money at $20 a share.  You then watch the stock tank to $5 a share due to a poor earnings report driven by the poor economy.  However, you firmly believe in the company and have supporting data behind it, and you know the stocks will recover if you hold long enough. It would be a shame if you were forced to sell the stocks at $5 a share simply because you borrowed too much and are forced into a margin call.

I personally faced this challenge earlier on in my trading career.  I was forced to sell many stocks in the past only to see them recover in 2 weeks.  Learn from my experience folks.  If you are new to this and are thinking about opening up a margin account, think very carefully before making a regrettable decision.