Daily Investment Advice

Category: Short Selling & Margin

  • 5 Essential Considerations When Buying Stocks on Margin

    5 Essential Considerations When Buying Stocks on Margin

    Investing in individual stocks may be a cornerstone of your investment and wealth building strategy, which comes with many different risks. One advanced technique that amplifies both potential gains and potential losses is buying individual stocks on margin.

    Before diving headfirst into margin trading, it is essential to understand the potential pitfalls and risks of doing so. Today, we will unpack five key considerations you should consider before venturing off into buying stocks on margin. We will also discuss a hypothetical example illuminating how mismanaged risk can lead to substantial losses. If you are unfamiliar with margin trading, you may want to first read our article on the subject: Margin Trading for Beginners: 6 Tips to Avoid a Margin Call. We also discuss the basics of margin trading in our first point below.

    1. Understanding Margin Trading

    Margin trading involves borrowing money from your broker to purchase stocks. This method allows you to buy more shares than you could with your own funds alone. While this amplifies potential profits, it equally magnifies the potential for losses.

    Understanding the workings of margin trading is paramount. It’s not just about buying low and selling high, but also about managing the funds you borrowed effectively. Comprehensive knowledge about the margin trading process, including the specific interest rate being charged on the funds you borrow is important.

    1. Financial Health and Risk Tolerance

    Buying on margin should ideally be a strategy if you are an investor who is financially healthy and has a high risk tolerance. This is because if a trade goes south, you will have to repay your broker the margin loan (plus interest), even if it means dipping into your personal savings or selling off other investments to cover the balance.

    Before buying stocks on margin, you may want to evaluate your financial health and risk tolerance. Can you bear the financial and psychological stress of potential losses (which will be magnified when buying stocks on margin)?

    1. Market Volatility

    The stock market is inherently unpredictable. Changes in market conditions can dramatically influence stock prices. Consequently, margin trading becomes riskier in volatile markets because prices can swing negatively quickly. If your margin accounts value drops significantly, it could trigger a margin call, requiring you to deposit more funds or sell off securities.

    Understanding market trends and potential volatility can help manage the risks associated with margin trading.

    1. The Possibility of Margin Calls

    Margin calls are perhaps the biggest risk of buying stocks on margin. If the equity in your margin account falls below the broker’s maintenance margin requirement, you’ll face a margin call. You will have to deposit additional cash or sell some assets to meet the requirement, often on short notice.

    Ensure that you’re prepared for these situations and have a contingency plan to meet any sudden margin calls.

    1. Interest Rates

    Finally, bear in mind that brokers charge interest on the money you borrow for margin trading. These interest rates can vary, and it’s important to account for them when calculating potential profits. If the interest charges eat into your profits significantly, it may not be worth the extra cost.

    An Example of What Can Go Wrong

    Now, let’s delve into a hypothetical scenario illustrating the risk of margin trading. Suppose you buy $10,000 worth of stock XYZ on margin, with your own funds covering half ($5,000) and the broker loaning the rest. If the stock price rises by 20%, you sell the stock for $12,000, repay the broker $5,000, and make a net profit of $2,000 – a 40% return on your initial investment.

    However, consider the stock price falls by 20% instead. Now, the stock is worth only $8,000. If you decide to cut your losses and sell, after repaying the broker, you’re left with $3,000. This is a loss of $2,000 on your original $5,000 investment – a massive 40% loss. If the stock price falls drastically, you could even end up losing more than your initial investment.

    The above hypothetical scenario underscores the potential risks inherent in margin trading. Hence, while the prospect of amplified returns can be enticing, always remember the potential for amplified losses.

    To Summarize

    Buying individual stocks on margin can be a powerful tool for seasoned traders with an appetite for risk and a keen understanding of the market. However, before considering margin trading, it is crucial to thoroughly understand how it works, your financial resilience, your tolerance for risk, the volatility of the markets, potential for margin calls, and the impact of interest rates on profits.

    By being well-versed in these key considerations and managing risks prudently, you can better navigate the exciting yet tumultuous waters of margin trading. After all, the adage ‘knowledge is power’ rings especially true when it comes to investing in the stock market.

  • A Closer Look at Inverse ETFs: Shorting the Market with ProShares, Direxion, and iShares

    A Closer Look at Inverse ETFs: Shorting the Market with ProShares, Direxion, and iShares

    Exchange-traded funds (ETFs) have gained substantial popularity in the past decade due to their flexibility, tax efficiency, and accessibility. Among the wide range of strategies that ETFs allow investors to implement is shorting the market or benefiting from a decrease in the value of a market index. In this article, we’ll delve into three inverse ETFs that enable such a strategy: the ProShares Short S&P500 (SH), the Direxion Daily S&P 500 Bear 3X Shares (SPXS), and the iShares Short Treasury Bond ETF (SHV).

    ProShares Short S&P500 (SH)

    SH aims to provide investment results that correspond to the inverse (-1x) of the daily performance of the S&P 500. This means that if the S&P 500 decreases by 1% on a given day, SH aims to increase by 1%. Consequently, investors might consider SH in anticipation of a downturn in the S&P 500 or as a hedge against long positions in related assets.

    Direxion Daily S&P 500 Bear 3X Shares (SPXS)

    SPXS offers a leveraged inverse (-3x) daily exposure to the S&P 500. This means that if the S&P 500 drops by 1% in a day, the fund aims to rise by 3%. This enhanced inverse relation provides a means of amplifying potential gains from a downturn in the S&P 500 but also amplifies potential losses if the S&P 500 increases. Hence, SPXS is a riskier proposition than SH, given its leverage.

    iShares Short Treasury Bond ETF (SHV)

    Unlike SH and SPXS, SHV isn’t directly related to a broad equity index like the S&P 500. Instead, it offers exposure to U.S. Treasury bonds with maturities between 1 month and 1 year. If interest rates rise, short-term bond values typically fall, potentially providing a return for SHV. Though not a direct inverse relation to a broad equity index, it can serve as a hedge against rising interest rates. As of September 2021, SHV’s expense ratio is 0.15%, substantially lower than both SH and SPXS due to its different nature and objective.

    Understanding Short Selling Strategies

    So how do these funds implement a short selling strategy? At a basic level, short selling involves borrowing a security, selling it at the current price, and then buying it back later (hopefully at a lower price) to return to the lender. The short seller pockets the difference if the security’s price decreases. Conversely, if the security’s price increases, the short seller incurs a loss.

    In the context of ETFs, managers employ various financial instruments to achieve the inverse relation to an index. These include futures contracts, options, and swap agreements, which they use to create a synthetic short position. This way, they aren’t required to borrow and sell individual securities, which would be impractical for replicating an index.

    Keep in mind, these ETFs typically aim to achieve the inverse performance on a daily basis. Over longer periods, the returns can differ significantly from the inverse performance of the index due to the compounding effect. This is especially pronounced in volatile markets and for leveraged funds like SPXS.

    Conclusion

    Inverse ETFs offer a unique tool for investors looking to hedge against or benefit from downturns in the market or specific sectors. However, they also come with elevated risks and expenses. The three funds we explored illustrate different strategies and degrees of inverse exposure, each with distinct risk and return profiles.

    Before investing in these or any other ETFs, you should carefully consider your risk tolerance, investment goals, and the costs associated with each fund. Moreover, you should understand that the performance of these funds over extended periods can significantly diverge from the one-day inverse performance they aim to provide due to the effects of compounding.

  • Margin Trading for Beginners – 6 Tips for Avoiding a Margin Call

    Margin Trading for Beginners – 6 Tips for Avoiding a Margin Call

    Buying stock on margin essentially means purchasing stocks with borrowed money from a brokerage firm. In other words, an investor opens a brokerage account (perhaps with an online broker) and borrows funds from their broker to buy securities.

    Margin trading can allow you to increase your potential returns, as you can invest more money than you actually have. However, it also increases potential risks, as you are now exposed to not only the risks of the stock market, but also the risks associated with the borrowed funds.

    When buying stock on margin, you must maintain a certain level of equity in your account, known as the margin requirement. If the value of the stocks held in your account falls below this margin requirement, you will receive a margin call and may be required to deposit additional funds to maintain the minimum equity level. If you fail to meet the margin call, the brokerage firm may sell your securities to cover the borrowed funds, which can result in significant losses.


    Here are 6 tips to help you avoid a margin call:

    1. Understand the Margin Requirement: Make sure you understand the margin requirements of your broker and the securities you are trading. Different brokers may have different margin requirements, and they may vary depending on the type of securities being traded.
    2. Monitor Your Account: Keep a close eye on the value of the securities in your account and the amount of margin you are using. Regularly monitor your account and make adjustments as needed.
    3. Diversify Your Portfolio: Diversifying your portfolio can help reduce risk and minimize the likelihood of a margin call. Avoid overconcentration in a single security or sector.
    4. Don’t Overextend Yourself: Only borrow what you can afford to pay back. Avoid taking on too much debt or using too much leverage.
    5. Have a Plan: Develop a trading plan and stick to it. Don’t make impulsive trades or let emotions drive your investment decisions.
    6. Keep Cash on Hand: Maintain a cash reserve in your account to cover unexpected margin calls. This will help ensure that you have the funds you need to meet margin requirements and avoid forced selling of securities.

    Remember, buying stocks on margin can be a risky strategy, and it’s important to fully understand the risks before using margin. If you’re unsure about margin trading or need guidance on managing your margin account, consider consulting with a Financial Advisor or a professional with expertise in margin trading.

    Example of Potential Profits from Margin Trading

    Let’s say you have $10,000 in cash and you want to buy 100 shares of a stock priced at $100 per share. If you buy the stock outright, you would spend $10,000 and own 100 shares.

    However, if you buy the same 100 shares on margin with a 50% margin requirement, you would only need to put down $5,000 (50% of $10,000) and borrow the other $5,000 from your broker. If the stock price increases to $120 per share, you would sell your 100 shares for $12,000, resulting in a profit of $2,000 (20% return on your initial $10,000 investment).

    But keep in mind that buying stocks on margin also increases your risk. If the stock price goes down instead of up, your losses will be amplified by the borrowed funds, and you could potentially receive a margin call if the value of your investment falls below the minimum margin requirement. An example of this scenario is discussed below.

    Example of Potential Losses from Buying on Margin

    Let’s say you have $10,000 in cash and you want to buy 100 shares of a stock priced at $100 per share. If you buy the stock outright, you would spend $10,000 and own 100 shares.

    However, if you buy the same 100 shares on margin with a 50% margin requirement, you would only need to put down $5,000 (50% of $10,000) and borrow the other $5,000 from your broker. If the stock price decreases to $80 per share, you would sell your 100 shares for $8,000, resulting in a loss of $2,000 (20% loss on your initial $10,000 investment).

    But since you borrowed $5,000 from your broker, you would still need to repay the loan with interest. Depending on the interest rate and the time frame, the interest charges could further increase your losses.

    If the value of your investment falls below the minimum margin requirement, you could also receive a margin call and be required to deposit additional funds to maintain the minimum equity level. If you’re unable to meet the margin call, your broker could sell your securities to cover the borrowed funds, resulting in further losses.

    Summary

    Buying stocks on margin can be a risky strategy that involves borrowing funds from a broker to purchase securities. While it can increase potential returns, it also amplifies risks and potential losses. To avoid a margin call, you should understand your brokers margin requirements (including the specific security being traded), monitor your accounts, diversify your portfolio, avoid overextending yourself, have a plan, and keep cash on hand.

  • Short Selling for Beginners – How to Make Money Short Selling Stocks

    Short Selling for Beginners – How to Make Money Short Selling Stocks

    Short selling is a strategy that is used by traders to profit from a decline in the price of a security. When short selling, the investor borrows shares of a stock from someone else (could be an individual or a brokerage firm), sells them on the open market, and hopes to buy them back at a lower price to return them to the original lender, thus profiting from the difference. 

    Example of Short Selling

    Let’s say you identify XYZ Company as overvalued and expect the stock price to decline. The current market price of XYZ Company is $50 per share. You decide to short sell 100 shares of XYZ Company.

    To do this, you borrow 100 shares of XYZ Company from your broker and sell them on the market at the current price of $50 per share, which gives you $5,000 in cash. You now owe 100 shares of XYZ Company to your broker, which you plan to buy back later at a lower price.

    A few days later, the price of XYZ Company drops to $40 per share. You decide to buy back 100 shares of XYZ Company at the current price of $40 per share, which costs you $4,000. You then return the 100 shares to your broker, and you’ve made a profit of $1,000 ($5,000 from selling the shares – $4,000 to buy them back) from short selling XYZ Company.

    However, it’s important to note that if the price of XYZ Company had risen instead of fallen, you would have incurred a loss. As discussed below, short selling involves significant risk, and it’s crucial to have a thorough understanding of the market and the specific stock before making any trades.

    Risks of Short Selling

    1. Unlimited Losses: When you buy a stock, the most you can lose is the amount you invested. However, when you short a stock, there is no limit to how much you can lose. If the stock price goes up instead of down, you may have to buy back the shares at a higher price than you sold them for, resulting in a loss that can be greater than your initial investment.
    2. Short Squeezes: A short squeeze occurs when a large number of investors have shorted a stock, and the stock price unexpectedly rises. Short sellers may be forced to buy back the shares at a higher price to limit their losses, causing the stock price to rise further, creating a feedback loop that can result in substantial losses for short sellers.
    3. Margin Calls: When you short a stock, you must borrow the shares from a broker, and this requires a margin account. If the value of the borrowed shares increases, your broker may require you to deposit additional funds into your account to cover the increased margin. If you can’t deposit the additional funds, your broker may liquidate your position, resulting in a loss.
    4. Timing Risk: Short selling requires a good sense of timing. If you short a stock too early or too late, you may miss out on profits or incur significant losses.
    5. Limited Upside Potential: Unlike owning a stock, short selling has a limited upside potential. The most you can earn from short selling a stock is the difference between the sale price and the buyback price, minus any fees and commissions.

    It is important to understand these risks and weigh them against potential profits before engaging in short selling.

    Here are 8 things you may want to consider if you are considering short selling stocks: 
    1. Identify stocks that are overvalued or have negative news or rumors surrounding them. 
    2. Research the stock and its industry to gain a better understanding of why the stock may be overvalued or facing negative news. 
    3. Find a broker that allows short selling and open a margin account. 
    4. Borrow shares of the stock you want to short sell from your broker. 
    5. Sell the borrowed shares at the current market price. 
    6. Monitor the stock and its industry news closely to determine when to buy back the shares at a lower price. 
    7. Buy back the shares at a lower price and return them to the original lender. 
    8. Profit from the difference between the price you sold the shares and the price you bought them back for. 

    Summary

    It is important to note that short selling is a risky strategy that can result in significant losses if the stock price does not decline as expected. As such, it is important to have a solid understanding of the stock and its industry before executing a short sale. Additionally, you should always consider your risk tolerance and consult with a Financial Advisor or other Financial professional if you feel it is necessary before engaging in short selling.