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TEN Exclusive: The Dangers of Margin Trading

The allure of big profits has dictated the style of trading since the millennia. Whether it is the casino, the racetrack, the bingo hall, or the stock market, we all are compelled in one way or the other to seek profits. As much as we would like to classify the purchase of stocks as investments, in all reality it is just another form of gambling. The school marm who invests in preferred stocks for the dividend would most likely be classified as the conservative gambler. The hotshot executive investing in the options and futures markets would be considered the problem gambler. In the middle somewhere would be the margin trader.

At first glance margin trading holds some real appeal. Instead of paying full price for a stock you only need to put up half. During a bull market, such as in the run, these gamblers made enormous gains. The problem was they were always fully leveraged. When the next hot IPO came out the margin trader would use most or all of their buying power to accumulate shares. There seemed nothing wrong with this when the markets were moving stocks up 30-40% per month. But alas, the bubble burst.

Having been on a trading desk during this time I can tell you it wasn’t a pretty time. When the equity portion in their accounts dropped below the firm minimum of usually 30-35%, they were issued a margin call. This means you need to come up with more money, or sell stock. Unfortunately, most of these traders were cash poor. Once stock starts getting sold it only fixes the problem for a short period of time. A domino effect starts to take place and with each downturn of the markets your equity gets sliced twofold. When it was all said and done most traders highly leveraged in the technology stocks lost 80% or more of their value. I saw some who lost it all. Retirements put on hold, educational funds lost, and lessons painfully learned.

The definition of insanity is doing the same things over and over again hoping for a different outcome. If anything from this last meltdown should teach us is playing with leverage can be a very expensive hobby.

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Disclosure: No positions