A Dangerous Trading Technique I NEVER Use
Dear Penny Stock Millionaire,
One of the most common (and biggest) mistakes I see new traders make is buying on margin. They do it before they have enough experience to understand the risks.
Most new traders enter the market with a few hundred or thousand dollars. That’s typically money they can afford to lose. But if you start trading with borrowed money or money you need to pay your rent next month… Things can go very bad, very fast.DON’T do it.
Trading is a dangerous profession. Scores of day traders lose money in their first year. It takes time to become consistently profitable. Save up some money and give yourself a real chance of becoming successful.
If you’re starting with a small account, let me explain why you should avoid buying on margin at all costs…
What Is Buying on Margin?
Buying on margin happens with nearly all asset classes. If you purchase a house, odds are you’ll buy it on margin. You put about 20% down and finance the remaining 80%.
When you buy anything using margin, it simply means a part of the purchase is borrowed money from a bank or a broker.
The same way you can buy a house with a small down payment, traders can buy stocks on margin to increase the number of shares they’re eligible to purchase. This can be tempting for a lot of people…
Buying stocks on margin — in theory — can allow traders to make more money quickly. But the risks are substantially higher.
In the U.S., traders and investors are limited by the pattern day trader (PDT) rule. One stipulation of this rule limits the level of margin accessible to traders with accounts under $25,000. While under the PDT, traders only have access to a 2:1 margin. So traders with $5,000 accounts can buy $10,000 worth of stock.
But traders over the PDT rule can buy stocks intraday on margin at a 4:1 ratio. That high level of leverage is very dangerous to inexperienced traders … but we’ll dig deeper into that in a bit.
Buying On Margin vs. Short Selling
I should mention, buying on margin isn’t the same as short selling. Both strategies require a margin account but have very different implementations.
When you short sell, you need a margin account. You’re selling an instrument you don’t own. The cash in your account is collateral for the position to ensure you’ll buy back the shorted shares in the future.
Buying stocks on margin uses the same collateral principle, but you’re using money you don’t have instead of selling a stock you don’t own. The cash in your margin account is the broker’s guarantee on the loaned margin. The broker will liquidate your position if your position moves sharply against you and puts their loan at risk.
So say you’re a trader under the PDT, using your full margin, and the stock drops by 50%. The broker has the right to liquidate your account. The liquidation clause is part of the margin account agreement you sign when you open a margin account.
How Do You Buy on Margin?
Before I explain this, I want to reiterate, If you are a new trader, I DO NOT recommend trading on margin, but if you are an experienced trader, and you are interested in learning how, read on… at your own risk.
The first step to buy on margin is to open a margin account with your broker.
Most brokers default new accounts to a cash account. Any trader can have a cash account, regardless of their credit history. Assuming you have a solid credit history, you can open a margin account with most brokers by filling out a simple form.
Next, you need to have enough money to meet the broker’s margin requirements. Every broker has a different margin requirement. Some overseas brokers have a margin requirement as low as $500. Many licensed brokers in the U.S. have a margin requirement of $2,000.
Once you have a margin account, buying on margin is pretty straightforward. When you try to make a purchase, your broker will inform you of the amount of margin you can use on a given stock.
It’s common that volatile or sketchy penny stocks are margin restricted. That means you can’t use margin because the broker isn’t willing to lend you margin. However, stable companies like blue-chip stocks are rarely margin restricted.
You have to be smart with this leveraging power. You’d be surprised how often people message me because they blew up their accounts using margin … AND we haven’t even discussed margin interest costs yet.
Buying on Margin Examples
Most people are unfamiliar with buying on margin — they’ve always used a cash account.
So let’s walk through an example.
Let’s say you research company XYZ and think the stock will be an excellent investment for 2020. I’ll keep this simple and ignore any fees or interest charges your broker will charge you.
Currently, company XYZ trades for $100 per share. You’d like to purchase 100 shares of XYZ, which would cost you $10,000 without margin. However, you have a margin account under the PDT. Your broker allows you to use 2:1 leverage on the cash in your account.
Now, instead of having to use $10,000 to buy 100 shares, you only need to have $5,000 in your account. You buy the other $5,000 on margin.
After owning the stock for one year, XYZ’s price doubles to $200 a share. Since you were right about the investment, you decide to sell your shares and collect $20,000. But you gotta pay the broker back that $5,000.
Once you pay the broker back, you have $15,000. You tripled your account in one year. Those 200% gains are great, right? Let’s look at the other side of this story…
In another reality, stock XYZ had a tough year and lost half its value. It ends the year at $50 per share. You sell your shares for $5,000. Even though the stock lost its value, you still have to pay the broker back the $5,000 they loaned you. So one bad investment resulted in your losing your entire account.
The Bottom Line
So yeah … buying on margin can mean awesome gains…
But the harsh reality is the possibility of completely blowing up your account.
If you used a cash account in this case, you’d still lose money. But you wouldn’t have blown up your entire account on a single trade.
I don’t think that the risk is worth the reward. I believe in learning the rules, trading smart, taking small gains, and slowly building your account over time.
That strategy has worked for me and my students for a long time, and it’s why I’m still trading and teaching 20 years later.
Editor, Penny Stock Millionaires