Margin Trading and Market Timing – High Risk Investing

A margin trading account is a type of investment account offered by brokerages that allow investors to borrow money to buy securities. With a margin account, an investor can borrow funds from the brokerage firm against the value of the securities in their account. This allows the investor to increase their buying power and potentially increase their profits.

Margin Accounts

A margin trading account is a type of investment account offered by brokerages that allow investors to borrow money to buy securities. With a margin account, an investor can borrow funds from the brokerage firm against the value of the securities in their account. This allows the investor to increase their buying power and potentially increase their profits.

In comparison, a margin account has the option of leveraging. Leveraging allows investors to use borrowed funds, or a loaned financial instrument from their broker, to increase the potential return of an investment. It involves using a smaller amount of capital to control a larger asset base with the expectation of earning a greater return on the investment. This provides the investor with greater buying power. An increase in the money invested results in an increase in the potential returns (or profits). After closing a leveraged position, the borrowed funds or assets must be repaid to the broker along with interest.

However, leveraging also amplifies the effects of any losses, as the investor could end up owing more than their initial investment. This makes leveraging a high-risk strategy that should be approached with caution. It’s important for investors to understand the risks involved, and to have a solid investment plan before using leveraging.

Example

Let’s say an investor wants to purchase $100 worth of stock but only has $50 available. By using leveraging, the investor can borrow the additional $50 from their brokerage firm to complete the purchase. If the stock price increases, the return on the investor’s initial $50 investment would be larger than if they had simply invested the $50 on their own. The risk in this scenario is the investor could lose more money than they have. If the stock lost all its value, the investor loses $100 instead of $50. Plus, they would still owe the broker $50 plus interest.

Anatomy of a Margin Account

A margin account will have a combination of the investor’s own money, and money the investor borrowed from their broker. The amount that the investor can borrow from the broker is determined by the maintenance margin.

Maintenance margin refers to the minimum amount of equity that an investor must maintain in a margin account, as required by the brokerage firm. Maintenance margin is set by the brokerages as a measure to minimize risk. It ensures that investors have a certain level of equity in the account to cushion against potential losses and reduces the likelihood of margin debt. It’s given as a percentage of the whole account balance.

For example, if a brokerage firm requires a maintenance margin of 30% for a margin account with $10,000 worth of securities, the investor must maintain at least $3,000 (30% of $10,000) in equity in the account. If the value of the securities in the account decreases and the equity falls below the maintenance margin, the investor may receive a margin call from the brokerage firm, requiring the investor to add more cash or securities to the account to meet the minimum maintenance margin requirement.

A margin call is when the broker calls the investor and informs them that they must increase the cash amount in the account to meet the maintenance margin. The investor should deposit more money, and if they don’t, the broker has the right to sell any of the investor’s other investments to meet the maintenance margin of the account.

Short Selling

Short selling is a trading strategy where an investor borrows securities from a brokerage and sells them on the market, with the expectation that the price of the securities will decline. The investor then plans to buy back the securities at a lower price and return them to the brokerage, profiting from the price difference. Here’s how it works:

  1. The investor borrows the securities from their broker and sells them on the stock market at the current market price.
  2. They wait for the price of the securities to fall.
  3. Once it hits their desired target price, they buy back the securities at the lower price.
  4. The investor returns the securities to the broker, returning the borrowed securities.
  5. The difference between the initial selling price and the lower buy-back price is their profit.

The potential profit when short selling is 100% if the stock price, (i.e. if the stock itself) loses all value. Therefore, potential profit is limited.

There is a huge risk with short selling. If the price of the stock or financial instrument increases, the investor is at a loss. The stock price can reach any height and therefore the potential loss is unlimited. Investors short stocks or financial instruments due to speculation or if they want to hedge positions on investments.

Market Timing

Market timing is an investment strategy where an investor buys or shorts stocks and financial instruments based on their expectations of what might happen in the market. This is the buy low, sell high strategy, where investors try to buy stocks just before the price goes up, and then sells them at their peak.

The success of the strategy depends on how well an investor can predict the market. The investor’s predictions can be based on economic indicators or technical factors, such as trends. They would need to be very familiar and educated with using economic data and technical analysis to have a market timing strategy. Using these factors to decide which companies or industries to invest in or short sell. Trading styles can be either active or passive. Active investing means to frequently buy and sell securities. In comparison, passive investing is a buy and hold strategy. Market timing would fall under an active trading style.

Example

When President Trump was elected, using a market timing strategy to invest in banking stocks before the results of the election would have been very profitable. An analysis of President Trump’s policies would have suggested benefits for the investment banking industry. When he won the election, there was a spike in the stock price of investment banks. However, by investing in investment banks, investors were betting that Trump would win. Most investors had bet on Hilary Clinton winning. Therefore, their market timing strategy would have been unsuccessful.

Many academic studies have found that market timing is not a successful trading strategy; instead these publications favour long-term investment strategies. However, this is debated by active traders who argue in favour of market timing.

In general, it is considered an unreliable method of investing as the markets are unpredictable. The majority of investors who have a market timing strategy are unsuccessful. When comparing strategies, long-term investing strategies have many more success stories that their counterpart.

International Strategies

An international investment strategy is a method of investing in securities or assets outside of an investor’s home country. The strategy involves looking for opportunities in foreign markets to potentially achieve higher returns, diversify their investment portfolio, and hedge against risks such as inflation and currency fluctuations.

It reduces risk through diversification. Diversification is where an investor invests in more than one market to reduce the risk of exposure from any single one. In this scenario, an investor would have a smaller percentage of investments from their domestic market, with investments in foreign markets making up the majority of their portfolio. 

If an investor only held American-based securities, and the US market took a dive, it would be very difficult to protect themselves against taking a financial hit, (or loss). However, if they had investments in many international markets; the other investments would be safe, allowing their portfolio as a whole to be less exposed.

The trade-off to this extra diversification is more risk. Each country has unique political situations that could affect investments; which need to be carefully tracked and understood. International investing also exposes investors to currency exchange rates.

Currency risk is a significant consideration when investing internationally, as fluctuations in foreign exchange rates can have a significant impact on the returns of an investment. Political instability, such as changes in government policies, can also impact foreign markets and investments. Additionally, regulatory differences in foreign markets can affect the ability of investors to invest in certain securities or assets.

Given the complexities and risks involved, investors should carefully assess their investment objectives, and risk tolerance before implementing an international investment strategy. Conduct your own thorough research, and seek professional advice to ensure that your international investments align with your specific financial goals and needs.

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