For most people, investing involves a relatively linear path for risk.If you invest money in the market, the only real risk is that the capital you invested could go to zero. But sometimes, it’s worse than that. Here’s how you can lose more money than you invest in stocks.
Note that, for the most part, high-quality investments rarely go to zero except in very special cases.
There are assets and strategies in the markets, however, that offer investors various ways to make money that don’t involve the typical buy and hold investment strategies.
While they do tend to involve more risk, they also offer investors a higher reward potential.
So, how can you lose more than you invest in stocks?
The first step in any new investment concept is to understand how to manage the risk, so let’s examine the risks and help prepare you for the worlds of leverage and shorting.
What Is Leverage?
You might have heard the concept of using OPM – “other people’s money.”
It’s a phrase common in investing circles, and it means you are borrowing money from your brokerage or investment firm for the purpose of enhancing your profit potential on a single trade or on several trades.
When you borrow money from your broker, you are using leverage. It is also sometimes called margin.
How Does Leverage Work?
When you invest your money into your retirement account or standard brokerage account, you are usually doing so with cash.
This means that when you buy an asset your remaining investable funds decrease by exactly the cost to own the asset.
The amount by which your investable funds (sometimes also called “buying power”) decrease is called the margin requirement.
This type of cash account represents no risk to the brokerage.
However, some brokers will offer leverage to investors.
While they still take on theoretically no risk, there is the risk of an investor not paying up if the trade goes against them.
Cash only vs. Margin Investing
Let’s look at two cases where an investor buys 10 shares of Apple Inc. (AAPL) at a price of $140.00 per share.
A cash-only investor would have to put up the total cost of the trade, which is $1,400.00.
If the trade was placed by an investor who enjoys a 50% margin on stock trades, the trade would have a margin requirement of only $700.00.
Or put differently, this investor would be able to buy twice as many shares for the same initial investment.
Now, the first investor’s total risk on the trade is $1,400. If AAPL goes to zero, the investor will have lost only that $1,400.
Here’s where the pitfalls of leverage become clear.
If AAPL goes to zero for the second investor who opened the position on margin, he would lose the $700 initial margin requirement.
But he’d also owe the brokerage an additional $700 to cover the rest of the trade.
In other words, the investor with a margin would owetwice as much as they initially invested.
This is how you can lose more money than you invest in stocks.
There’s a bit more to it than this, but we’ll refer to this example again in another section.
What Types of Leverage Are There?
Some brokers and investment firms offer their investors the ability to borrow money that can be used in one of three ways:
- Decreasing the margin requirement to open a trade
- Increasing the leverage on a trade to improve profit potential
- Shorting an asset
Decreasing Margin Requirement
The first option is a bit more common in brokers that specialise in derivative markets like stock options and futures.
This is because those markets only deal with assets that are designed specifically to be leveraged.
The brokers that focus on stocks may indeed offer a 50% margin on trades placed by qualified investors.
This is what the second investor earlier used to open the trade.
Increasing Leverage
The second option is a tad bit more complicated.
When you take margin from a broker, you are actually taking out a loan from your broker in order to place a bigger bet on the market.
Not only does this increase your risk on the investment if it goes against you, but you will also owe interest on the loan as long as you hold it.
Now, let’s get to the third option, shorting, which needs a bit more explanation.
Shorting an Asset
Shorting a stock is an entire concept in and of itself.
And we have a whole other article explaining that in-depth, so do read that if you want to dig deeper.
But here’s the gist of it.
Selling short is the opposite of buying long. You are selling shares at a higher price in order to profit from falling prices.
Short selling can be seen as the third type of leverage because you are borrowing shares from your broker instead of money.
To help explain this concept, it helps to understand that most brokers and investment funds have some kind of inventory system to keep shares of many stocks on hand to ease the transaction when an investor wants to buy them.
When an investor sells a stock short, the broker lends the investor the shares from the inventory they want to sell at a given price.
If the price falls and the investor wants to take their profits, they:
- close the position,
- give the shares back to the broker at the prevailing market price, and
- keep the difference between the selling price and the price at which they bought the shares back.
Obviously, if the price of the stock goes up, the investor will lose money equal to the difference between the selling price and the buy-back price.
Shorting can introduce more risk than almost any other investment strategy, so make sure you take time to learn all of the risks involved before introducing it to your portfolio.
What Is A Margin Call?
In the Apple Inc. (AAPL) example from earlier, the second investor only had to put up $700 for a $1,400 position.
That means that, for the investor to lose his original $700 investment, Apple’s stock would only have to decrease to $70 per share.
So, what happens if Apple drops to $69.99 per share?
In that case, the investor’s broker would issue a margin call.
The investor would receive no less than an email, a text, a phone call, and a notification on the website or platform informing the investor that they have a set amount of time to either add money to the position or close it for a loss.
What If I Receive a Margin Call and Can’t Repay the Debt?
There is a very important thing to understand with all three types of leverage: while the profit potential increases, so does your potential for losses.
This is even more pronounced with shorting stocks.The price of a stock theoretically has no limit.
Because you’re betting on the stock to go down, you theoretically have unlimited loss potential.
In rare cases – such as the GameStop fiasco in the US in 2021 – investors can suddenly find themselves in a very bad position within a very short period of time.
RELATED: What is a Short Squeeze?
Brokers are allowed several protections with regards to ensuring margin is maintained.
This includes the ability to sell out of any of your other investments in order to cover the margin call.
If the broker has to close out all of your positions to cover the losses on the one that triggered the margin call, they will do it.
Not only that, even though you might have a few days to answer the margin call, if the losses spike too high in a very short period of time, the broker will take action as necessary to stop the losses, even if that’s the very next day.
What’s Next: Leverage & Shorting
Leverage and shorting are relatively accessible strategies investors can use to add a bit more versatility to their portfolios.
But they can also be surefire ways how you can lose more money than you invest in stocks.
Thus, the first thing that you need to understand before engaging in either of these strategies is to understand all of the risks involved completely.
Taking time to learn those risks can take some time, but you can always reach out for help from professionals with experience.
They can help you focus your learning path to become familiar with concepts like leverage and shorting far quicker than doing it yourself.
