Investing usually involves taking your saved cash and buying stocks or funds. You transfer the money, pick your shares, and wait for them to grow. But there is another method experienced traders use to amplify their potential returns.
It involves using the assets you already own as collateral to borrow more money from your broker. This strategy can magnify your wins, but it also increases your risk.
Buying Power
Your account dashboard will display a number labeled as buying power. This figure often looks much larger than the actual cash you deposited. When you investigate what is margin lending and how it functions, you will find that this number represents the total amount of stock you can buy including the loan.
It is essentially your cash plus the money the broker is willing to lend you. It is easy to feel wealthier than you actually are when looking at that inflated number. However, you must remember that you have to pay back the loan portion regardless of how your stocks perform.
Platforms such as SoFi aim to give investors tools to manage their portfolios, but the responsibility of handling leverage always falls on the user. You get to keep the profits on the total amount invested, but you also bear the full brunt of any losses on that total value.
A Sudden Cash Request
The biggest risk in this strategy comes when the value of your portfolio drops. Brokers require you to maintain a certain level of equity in your account. This is known as the maintenance requirement. If your stocks fall in price, the percentage of the portfolio that you actually own shrinks.
When your equity drops below the required minimum, the broker issues a margin call. This is a demand for you to deposit more cash or securities into your account immediately. You have to bring your equity back up to the minimum level. It can happen very quickly in volatile markets, forcing you to find cash when you least expect it.
Your Broker’s Right to Sell Your Stocks
If you cannot deposit new funds during a margin call, the broker will not wait for you. They have the right to sell your securities to cover the shortfall. They do not need to ask for your permission before making these sales.
The broker can choose which assets to sell to get the money back. They might sell the stocks you wanted to keep the most. They will sell them at the current market price, which is likely low since the market is dropping. You lose control over your portfolio decisions in this scenario.
How a Falling Market Can Trigger a Debt Spiral
Leverage works both ways. It multiplies gains when stocks go up, but it also multiplies losses when they go down. If you buy stock with 50% cash and 50% borrowed money, a small drop in the stock price results in a much larger drop in your personal equity.
This can lead to a situation where you lose more money than you originally invested. If the stock price crashes significantly, the sale of the stock might not cover the full loan amount. You would then owe the broker the remaining balance. It turns a bad investment into a financial liability that extends beyond your initial deposit.
