The problem with using margin leverage!

[SaulR80683]

THIS IS MEANT TO BE EDUCATIONAL AND IS NOT MEANT TO START A THREAD. DO NOT RESPOND ON BOARD!!!

The problem with using margin leverage, in simple terms.

Say you use margin (invest borrowed money) to juice your results, because you are sure in your mind which way your stock or index is going. You have taken enough margin that a 33% gain will become a 50% gain. Your $100, which would have grown to $133, will now be $150. Nice, but hardly noticeable. You have 12.8% more dollars.

But what if you are wrong? (Barely possible, I know, but let’s just look). Your $33 loss to $67 has become a $50 loss and you have only $50 left. Now that is a huge difference…… You need a 50% gain to get back to where you started from $67, but you need a 100% gain, a double, to recover from $50 !!! Was that worth the barely perceptible difference when you were right?

Now let’s go a little further and say you were insanely sure of yourself, and borrowed enough margin to turn a 33% gain into an 80% gain.

You were correct and instead of $133, you now have $180. Now that was satisfying, wasn’t it? You have 35% more dollars in your portfolio than you would have had without margin.

But what if you are wrong? Here’s where it gets grim! Instead of losing $33 and needing a 50% gain to get back to break-even, you lost $80 out of your starting $100, and you need a 400% gain! a 5-bagger! just to get back to break-even!!! You were essentially wiped out!

Was that worth that extra 35% more dollars on the gain???

And here you see the basic problem. It’s simple arithmetic. You are playing a version of double-or-nothing. You can be right most of the time, but one wrong guess… well, you saw the numbers….

Best,

Saul

[RafesUserName]

(I hope this addition is acceptable. This is not a discussion or anecdote.)

One very important point to add to this is the Margin Call. It allows your broker to automatically liquidate your holdings to cover the margin if the price goes down enough to trigger the call, locking in big losses. Without margin you have the option to wait it out as a long-term investment, but the Margin Call sells your investments indiscriminately at the worst time.

This risk is amplified for a concentrated portfolio with high volatility!

Imagine having a high percentage of margin when the pandemic hit. Your portfolio would have been wiped out, sold from under you, leaving you with nothing to invest in the recovery.

[JustAName]

Saul, I completely understand how using margin creates leverage, in that it magnifies the impact of any losses or gains. However, as long as you don’t get hit with a margin call, I’m not sure your example plays out the way you described: The stocks you bought with the margin remain in your account. If they go up by 50%, you’re back where you started at, same as if you dropped 33% without margin. You’re right in that you would need a 100% gain on your equity in the account, but the net value of the account looks the same as it would if you didn’t have margin.

[stocknovice]

as long as you don’t get hit with a margin call

You might not have meant it this way, but this reads almost like a casual dismissal of margin calls. The truth is margin calls are exactly what ruins people when the s*!t hits the fan.

but the net value of the account looks the same as it would if you didn’t have margin.

I am not sure I follow your point here. Are you saying not to worry because the numbers all look the same when viewed through the number of shares you own? That’s fine, except you still owe the original money you took on margin plus whatever interest exposure remains. I don’t see where you account for this in your comment. Maybe I’m reading it wrong, but it sounds like you are saying it’s still the same TV whether I bought it in cash or paid by credit card. Those two things couldn’t be more different, especially if you are making minimum payments. Margin is like the credit card of investing. Brokers don’t offer it because it is cost-neutral for clients.

I know Saul specifically asked for no responses to his original post, and here I am tacking a third response onto this thread. I sincerely apologize. However, I couldn’t let the last post go without responding because any new investor taking these comments at face value without understanding the dangers of the math behind margin could end up in a world of hurt.

I have no interest in getting into a debate over this. Anyone arguing that margin has limited risk clearly hasn’t had their a$$ handed to them. Trust me, it only takes once to learn this very valuable lesson. Please, please, please take Saul and others at their word and think VERY carefully before heading down the margin path.

Again, I apologize because I feel we are quickly crashing off topic.