By now you have purchased some stocks (maybe sold some as well) and have likely explored index funds or mutual funds. Maybe you dabbled in bonds and CDs a little bit, but these things just aren’t making you the money you thought they would. You want to explore some of the more lucrative types of trading you have maybe heard about in movies or from friends in the business. While these things are available to you, it’s important to understand that the higher the potential reward the higher the risk you put yourself into. We in no way encourage any specific type of trading but believe everyone should be well-informed before jumping into risky trades. To get started let’s discuss a few common terms.
Margin
This is a term used when buying stocks or other investment options using money that you are “borrowing”. There are certain types of trades that you can only do on margin. Most brokers will give you a multiple of whatever cash you have on your account as a margin (Ex: if you have $30k in your trading account you may be offered $60k in margin). This works similarly to a loan, and you must pay interest on any funds you use to buy or sell on margin.
Pattern Day Trader
If you are buying and selling stocks multiple times daily, you may run across this term. You can avoid pattern-day trading violations if you have over $25k in your trading account. If you have under this, you will want to wait until the funds clear after each sale prior to buying more stock (which can take several days between trades).
“Shorting”
This term is used to describe selling something you do not currently own with the expectation of replacing the thing you “sold.” If you believe a stock will go down in value in the immediate future, you could sell that stock short. Imagine it this way: Your friend has a PS5 that he isn’t using, and PS5s currently sell for around $500. You tell your friend you want to sell their PS5 today for $500 and you promise to give them another PS5 in a couple of months when the price drops. He agrees and when the price of the PS5 drops down to $400 you buy him a new one and you just made an easy $100. Shorting stocks is slightly more complicated than this but essentially works the same way.
Risks of these types of investments
When you buy a stock normally, the most you are risking is whatever the cost of the stock is. If I buy a stock for $100 and that company goes bankrupt, I can only lose $100. With margin and shorting those losses have no maximum loss. Let’s look at the unique risks of margin trades and shorting:
Margin risks
When you are trading with borrowed money, you risk not only losing the money that you have put into your account but also having to pay back whatever you borrowed. If you put in $100 and your broker gives you $200 on margin this essentially gives you $300 in buying power. Let’s say you decide to buy $300 worth of stock. You start accruing interest immediately on the $200 you are using that isn’t yours. Now let’s say that company goes bankrupt. You have now lost your initial $100 and you now owe your broker $200 plus any interest for as long as you borrowed that money. While your broker may loan you the money on margin, they expect you to get paid back regardless if you lose money or not. There is also the chance of a margin call. Let’s say in that same scenario the $300 worth of stock you bought dropped in value and was now only worth $50. You may believe in the company and that the stock will rise in value if you wait long enough, however, your broker says they will no longer loan you the money since your account has dropped and require you to put more money into your account or force you to sell out of your position so they can recoup some of their losses.
Shorting risks
Shorting a stock leverages margin in most cases so you automatically have the risk of paying interest on any amount you short while you are waiting for the stock to drop. Shorting stocks also have limited upside. If I short a stock that is currently trading at $100 a share, the most I can make from shorting that stock is $100 (if I short the stock and it goes to $0 then I’ve maxed out what I can make on that short). However, if stock prices go up instead of down, you can find yourself owing a lot of money. Imagine the same example with your friend and the PS5. In this example though let’s say that instead of the PS5 prices going down to $400, there is a shortage in supply and the price goes up to $1,000. You owe your friend a PS5 no matter what they cost so now you must go and spend $1,000 and buy him one so you have essentially lost $500. Margin calls can also force you to put more money in to hold onto your positions or force you to buy out of them if you end up going into the red too much. This is exactly what happened with stocks like GameStop and AMC. Many traders lost millions because they shorted stocks that skyrocketed and they were forced to pay outrageous prices to buy those stocks back.
