12/12/2018 |
Risks and Benefits of Trading on Margin
For any trader, leveraging funds can be crucial to generating the returns they are looking for from investments. Whether trading Forex, Futures or other derivatives, margin accounts are commonplace, offering traders and investors the opportunity of controlling a bigger stake in the market than their deposited funds would otherwise allow.
It sounds like the perfect approach for anyone, however, there are things to consider when looking to use a margin account and being aware of the potential downsides is especially important. Understanding the differences between a standard cash account and a margin account, and what it means for your risk, as well as using leveraged investment effectively while managing that risk, are skills that investors and traders need to master.
Cash vs. Margin Account
When setting up an account with a broker, once you have chosen the specific broker themselves, this is one of the first choices you make as a trader. Understanding the difference between how each work is important because it changes the level of risk you are exposed to at any time. This is important because managing risk is one of your key challenges when trading the financial markets.
The cash account is the simplest type of account a broker can offer to you. It allows you to trade in most markets you would wish to be involved with and has no additional risk. You deposit funds into your account, and then you can take positions by paying for them out of that account fund. If you don’t have enough money in the account to cover a position, you must either add funds or close another trade to release funds back to your account, before the new trade may be placed.
This approach introduces no additional risk and offers an easy-to-manage, conservative approach. Cash accounts also have an additional restriction, only allowing for long positions, that is buying the stock or derivative in question. Short positions, to take advantage of falling markets, are not available to the cash account trader.
A margin account, on the other hand, has two very unique features. It allows traders to short sell, that is to trade a falling market, but most importantly, allows an investor to leverage their funds to make larger trades. Leverage simply means that you can control a larger amount of capital than your account would normally allow. For instance, a 2x leverage means that for every $1000 of capital you have in your account, you could actually control $2,000 of stock.
This leverage is achieved in a margin account by using the cash and securities in the trading account as collateral for a line of credit to buy stocks and other instruments. There are some things to remember here, borrowing means interest is charged. This is usually a relatively low rate usually, certainly less than a credit card, but it is still an additional cost for your investing activities and which will require larger returns on positions taken to compensate.
Going Short
We mentioned it briefly earlier, but one of the significant changes that a margin account introduces is the ability to short stocks and other securities. In the traditional investment position, the security is bought at its market price and then sold at a later date when the price has risen. The difference between the purchase price and the selling price is the profit on the trade, less any brokerage costs and so on.
Figure 1: A simple chart of the $SPY showing where traders with long positions in the market would make money vs. when traders with short positions in the market would make money.
In a short position, a trader will sell the market price of a security from their broker and then seek to buy it back at a lower price in the future as the market falls. Again, the difference between the purchase price and selling price is the trading profit, although they occur in a different order. So, how is it possible to sell something before you buy it? The answer is in a margin account, you borrow those securities from your broker to sell them on the open market and pocket the cash. How do you close the account? Well, you simply return those shares to your broke at (hopefully) a lower price.
It can be difficult to see how you profit from this, but if we look at each stage of the process and it makes sense. You sell the security at a higher market price, and then buy the same amount of shares back at a lower price after the market falls. Technically you are still buying low and selling high but you first sell high and then buy low whereas, in a long position, you buy low and then sell high.
Figure 2: Scenario 1 shows how someone can be profitable from a short sale and Scenario 2 shows how someone’s account can quickly go underwater if the stock moves up quickly. The end result is a margin call.
Shorting is not without risk though. To start, it adds significant costs to a trade. There is the margin interest that is associated with all trades on a margin account, but in addition, stock borrowing costs are incurred too. These vary depending on the stock or other security in question, and they are based on the difficulty in borrowing that particular security.
In addition to the additional costs that must be taken into account when assessing potential returns, there are other risks too. One is known as the short squeeze, which occurs when a heavily shorted stock or other security rapidly moves upwards in price, forcing short sellers to close their positions. This selling further increases the upward move, resulting in a continuous motion that pushes the short sellers out, the majority in losing positions.
That upward move can be caused by a potential turnaround of the security due to a change in circumstances or other fundamentals and generally is only a brief movement. However, it only takes a few short sellers to be pushed out to create the bigger move especially if the market is not very liquid.
In addition, there are regulatory risks, with bans being imposed on short selling in certain markets from time to time, usually resulting in a price spike. For those in short positions at that time, it can cause huge losses.
Unlimited Liability
While all those dangers and risks are manageable, there is one other aspect of short selling that must always be remembered. This sometimes misunderstood danger is called unlimited liability, which is when a trader can lose more than they originally put in. That is, if the price goes against you, there is no limit to the upward range any stock price can move. Theoretically, it can keep rising. Because these are margin trades and leveraged positions, it is very easy for losses to pile up quickly. Once your exposure, that is the amount you have lost, exceeds a certain level of maintenance margin required in your account, the ratio between exposure and deposited funds, then you would be subject to a margin call.
Figure 3: This example shows what happens to someone who has “unlimited liability” from shorting a stock on margin.
Figure 4: This example shows what happens to someone who has limited liability from going long on a stock.
The margin call is the situation where the broker asks for a further deposit to cover the leveraged losses being incurred in a position. Because a stock has no limit to how far it can rise then, this could theoretically never end.
That is the key risk, and if a margin call takes place, the choice is to continue the trade or accept current losses. That unlimited risk is unique to short positions, if you think about a traditional long trade, then the lowest the stock price can go is to zero. There is always a limit on the losses in a way that a rising price will never have.
Figure 5: A movie was made in 2011 about a firm dealing with a margin call and having to liquidate its positions in the market.
Panic Buying
The driving factor of the short squeeze is the panic buying as short sellers try to get out of positions they have. This is driven by both accruing losses, and by knowing that such losses are not limited as a stock that is heavily shorted begins to rise. This spiral begins as a heavily shorted stock turns for whatever reason. It could be a small piece of news that hints at a turnaround, causing confidence to rise enough to push the stock higher, it is often just a temporary move.
But it is what that causes that is the main driver for a continued rise. As short sellers are placed into losing positions by the temporary rise, they have a choice. Get out at a loss or hold and hope for a retracement. As we know, fear is a powerful emotion, and for many, it results in taking the loss and getting out. But because getting out of a short position means buying the stock, that further drives the price higher, catching more short sellers into losing positions, and so on.
Figure 6: This chart shows an example of a short squeeze that occurred in $OGEN. Over 60% of the float was short at one point which set up the massive squeeze that occurred in September 2018.
That cycle of panic buying causes the rapid, albeit often temporary, rise in stocks that signify a short squeeze, and there have been many instances over the years. One of which involves James Cordier, who was the owner of the hedge fund optionsellers.com. A long-time promoter of naked selling, that is, taking positions without any hedging against risk, Cordier specialized in energy futures, both in his books and in the management of his hedge fund.
While US natural gas had been a steadily falling market all year, in November 2018 everything changed. Prices turned, rising as much as 20% in a day in both gas and oil stocks. This rapid upward move caught out many short sellers, in particular, Cordier and his optionsellers hedge fund, which was completely wiped out by the losses.
Figure 6: Natural gas chart showing how out of out of money calls worked and how the chance of options in that area was low.
Conclusion
Margin accounts bring several new opportunities for investors, both with the ability to leverage your funds to take on larger positions and the larger profits they potentially bring. The ability to enter short the market from downward swings is also a plus that traders cannot enjoy with a cash account.
However, there are downsides to this such as increased risks and costs that affect the profitability of your trading strategy. That is not to say that short selling and margin trading should be avoided, but that it is important, even more so that a traditional cash account trade, to be aware of the overall risk of a short trade before entering.
