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On a previous article, the fundamentals of Margin Trading have been discussed. To recap, margin trading is so much like having a good friend cover your back when you’re in need. For example, imagine you’re in a casino and playing poker. After a few losing rounds, your capital might run out but you still want to play or at least take back what you’ve lost. This is where your good friends would come in. He’d offer to lend you an amount of money that you’d pay back after your game.

That’s putting it simply, but margin trading is anything but. I have already explained the advantages of this strategy, and now it’s time to introduce to you the risks it entails.

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Example

Excluding margin calls and equities, parallel to the previous article’s example, Mr. Cruz has $10,000 of his own money and decided to margin trade with a broker who loaned him another $10,000 so he now has $20,000 worth of buying power. Initially, he bought 200 shares from Apple worth $100 each, expecting that it would rise. By now he has used up everything in his margin account. Unluckily, Apple’s newly released iPhone didn’t meet people’s expectations and this resulted in a 25% drop to the shares’ price instead of increasing. The shares are now worth $75. If Mr. Cruz decided to cash out, he would be indebted 50% from his initial margin. This is the very reason why margin trading is very risky.

Before trying this strategy, it is advised that traders make intensive research, invest on the right broker, know all the risks this entails, and learn how to manage it.

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Disadvantages

·         When stocks are sold in a margin account, the proceeds go to the broker first as a payment to the loan and its interest until it is fully paid. The rest goes to the trader.

·         The interest rate charges are applied to the trader’s account unless they decide to make payments. Over time, their debt level increases as interest charges accrue against them. As the debt increase, the interest charges increase.

·         Not all stocks qualify to be bought on margin.

·         If traders hold an investment on margin for a long period of time, the odds that they will make a profit are against them.

·         If margin call is missed, the brokerage has the right to sell traders’ securities to increase their account equity until they are above the maintenance margin, without consulting the traders.

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