Trading on margin can be very risky and it is not suitable for everyone. There are a number of risks that you have to consider in deciding to trade securities on margin.
- Your loss would be magnified if your stake declines in value. For example, the stock you have bought for $100 drops to $50. If you have paid for the stock in full, you would lose 50% of your stake. But if you have bought the stock on 50% margin, you would suffer a 100% or total loss! Always remember that leverage works both ways.
- You may have to put up additional cash or securities to meet the margin call. A decline in the value of collateral put up may require you to deposit additional cash or securities into your account on short notice to cover market losses and to avoid forced liquidation of securities in your account. Apart from decrease in collateral value, margin calls may arise due to securities held as collateral being suspended for trading. For example, under the Financial Resources Rules in Hong Kong, securities suspended for at least three business days are assigned a zero value. Therefore, if any of the securities you have deposited as collateral are suspended for trading, it is likely that you would be asked to put up a large amount of additional collateral to cover the entire value of the suspended securities.
- You may be forced to sell your securities. If the value of your securities falls below the margin requirement of your brokerage, you may be forced to sell your securities to cover the margin deficiency - whether you like it or not.
- You may lose more than your margin deposit under forced liquidation. If the proceeds from forced liquidation are insufficient to cover the margin loans, you will not only lose all your margin deposit but will also be liable to the remaining shortfall in your account.
- Your brokerage may sell your securities without consulting you. Some investors mistakenly presume that a brokerage must contact them for a margin call to be valid, and that it cannot cash in the securities held on their accounts to meet the call unless they have been consulted. This may not be the case. As a matter of good customer relations, most brokerages may attempt to notify their customers of margin calls, but they are not required to do so. Some investors have been shocked to find out that a brokerage has the right to sell the securities held in their accounts - without any notification and at a substantial loss to the investor.
- You may not be entitled to an extension of time on a margin call. While an extension of time to meet a margin call may be available to customers under certain conditions, a customer is not supposed to have a right to the extension.
- You may lose all your securities if your brokerage is insolvent. When a brokerage is wound up or liquidated, and if margin clients have authorised the firm to re-pledge their securities with a bank, the bank may liquidate these securities to discharge the firm's indebtedness. Depending on the terms of the authorisation, margin clients may not be able to get back all the securities in their accounts. This is known as the "pooling risk".
- A rash of margin calls could make a steep market sell-off steeper. Declines in stock prices will trigger margin calls and some investors are forced to sell stocks at a loss. An eruption of margin calls and the corresponding forced liquidation could intensify the selling, which in turn will drive the market down further during a market downturn and the next wave of margin calls, and so on.
It is important that investors take time to learn about the risks associated with trading on margin. Brokerages should provide a risk disclosure statement in the language the client prefers, investors should also clarify with their brokerages regarding any concerns they may have with their margin accounts. For inexperienced investors, be sure to seek professional advice on the suitability for you to trade on margin in light of your investment objectives, risk tolerance and financial positions.