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I'm one of the newbie retail investors that this guy (and presumably a lot of his colleagues) seem to hate.

Ironically, my biggest loss was from agreeing with specialists that the recent rally is bogus, and attempting to profit by shorting stock. In April. Thus I learnt a valuable, if costly, lesson on the risk of short-selling: if your target stock doesn't go down soon, it likely never will (†).

What I don't understand is the implication I sense from Chief Hater-of-the-Noobs up there that those who buy on leverage also stand to lose badly. I understand how one can lose all when buying on huge leverage - buy on 10x leverage, stock goes down 10%, your investment is gone. But is this really a risk for those on more reasonable leverage, like 2x or 5x? Can't one simply sit calmly and wait for the prices to recover (†)? Even in the March crash, a lot of companies only went down around 30% in value, so taking a total loss on reasonable leverage doesn't seem that likely.

Is there something that I'm missing?

† My underlying assumption is that, for most stocks, the week/month/year average price does go up eventually.

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    Leverage is a double edged sword. If you're on 50% margin, you make twice as much if your security rises and you lose twice as much if it declines. As for your link, the implied message that Robinhood traders are moving the market is nonsense. Institutional traders are responsible for the majority of trading today. Robinhood accounts are typically smaller accounts and compared to the total number of investors and traders at other brokerage firms, Robinhood is a nothing burger. As for shorting, it should only be done by experienced traders practicing disciplined risk management. Jun 15 '20 at 14:37
  • I do agree, including on what a bad idea shorting is for beginners. I don't agree with the article either, but I wanted to see if the guy knows something about leverage that isn't obvious (like N x leverage means you can lose money N x faster)
    – Makotanist
    Jun 15 '20 at 14:58
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    The first time I shorted was Compaq in the 90's. I learned the hard way that you have to have a plan in place beforehand and stick to it. Now, it doesn't phase me at all. For trading, I'd rather short on a down day than go long on an up day because markets fall faster than they rise. Markets don't melt up :->) Jun 15 '20 at 15:13
  • If you're on 5x leverage then you lose all your investment if the stock goes down 20%. Some people think there's a massive stock bubble right now. If those people are right, the stock price could go down 50% and then you will owe money to your broker.
    – user253751
    Jun 16 '20 at 17:39
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    Does this answer your question? Should I invest on margin?
    – nanoman
    Jun 17 '20 at 6:48
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https://blog.mint.com/investing/the-dangers-of-leverage-and-some-solutions/ explains this pretty well. It's a lot like other risk calculations in that you can get bigger gains with leverage, but losses can also be larger. The other people whose money you're using are also going to want that money back whether you are operating at a gain or a loss.

But wait a minute. Now look at the other side of the leverage equation. If your $50 stock loses three points, you are down $300 and shares are only worth $47. If you used margin and bought 200 shares, the three-point drop takes your value down $600.

Something else also happens here. Your $10,000 investment fell to $9,400, but half of the original, or $5,000, was borrowed and you still have to pay that back. But based on current value of $9,400, you are only allowed to borrow half, or $4,700. So you will get a margin call, a demand for you to deposit $300 more in your account to maintain that 50% ratio between your money and your leveraged money.

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    Michael C. Thomsett is a respected option author (your link). His margin explanation is utterly incorrect. If the maintenance requirement is 25%, the margin call occurs at 4/3 the loan value. So if $5k is borrowed to buy $10k of stock (50% margin), the maintenance level is 4/3 * $5k or $6,667. That means that there will then be $1,667 of equity on a $5k loan or 25% margin. If account value drops below $33.34, a margin call will be issued and in many cases, the broker will simply close the position. Jun 15 '20 at 14:22
  • I think Bob Baerker is closer to the truth. I just made a (virtual) buy of a 2x CFD on a stock that costs ~105$. The lowest Stop Loss I can set without adding extra money is ~79$, which would be close to 3/4. Actually, I was expecting margin calls to happen at (L-1)/L, so 50% for 2x. The logic is, the borrower takes back their loan, with your 1/L paying for the losses. You get left with 0. Why is it different?
    – Makotanist
    Jun 15 '20 at 14:46
  • @BobBaerker, maybe you can make a proper answer from your comment? I think margin calls being harsher than I thought is why I was missing.
    – Makotanist
    Jun 15 '20 at 15:05
  • @Makotanist You refer to 5x leverage as 'reasonable', so I do think you are underestimating the impact leverage has on risk. Jun 15 '20 at 15:17
  • @ Makotanist - For CFDs, I have nothing to offer since I don't trade them nor do I know anything about them. And FWIW, in the US, not only is long margin is different than short margin but brokers can require higher levels than Reg T allows. Jun 15 '20 at 15:17
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You appear to be severely underestimating the risk associated with (a) investing with leverage; and (b) shorting stock. As well, you defend your actions by saying you 'agreed with the specialists', but keep in mind that there is never unanimous agreement over what will happen in the market, and even if someone knew with 75% certainty that a stock will go down, there is still a 25% chance it goes up instead.

Why does leverage increase risk?

Risk in finance is defined as the variance in possible returns. So if your possible return on being right is to double your money, and your possible risk on being wrong is to lose everything (like betting $5 on the flip of a coin), your risk is massive. If your possible return on a simple equity investment is 10% over the course of a year [a high-end estimate of a good stock market return], and your risk of being wrong is -10% over the year [which would be a devastating 1-year return], your variance in outcomes only goes from 90-110%, so you your risk is lower.

But when you borrow money to make that lower-risk investment, look what happens: Assume you invest $50 of your own money, and $50 borrowed money. If the stock goes up 10%, your investment portfolio is worth $110. Because you only used $50 of your own money, your net equity earnings are $10 / $50 = 20%. ie: you have doubled your rate of return from 10% to 20%. If you like, you could immediately pay off your $50 loan and be left with $60, which again shows the 20% earnings. Now assume the same scenario, but the stock drops by 10%. Your total portfolio drops to $90, a loss of $10 off of your $50 personal cash invested (ie: a 20% loss). So the variance in possible return has moved from 90%-110%, to 80%-120%. Your risk has effectively doubled, because half of your investment comes from borrowings.

Now imagine you had 5x leverage, meaning $1 equity for every $5 of borrowed funds. So if you invested $600 in the market, and it dropped by 10%, you would go down to $540 in value. But you would still owe $500! So you will have dropped your $100 equity value down to $40, meaning you would turn a 10% market loss into a 60% personal investment loss!

And every day you wait for the market to recover [which is not guaranteed to happen, particular in a short enough time frame that you can rely on it like this], you have to pay interest costs, meaning at say 5% interest annually, you might add another $25 / year in interest costs, or about $2 / month (which is 2/ 40 = 8% of your current $40 equity value, being lost every month to interest!).

As well, keep in mind that when shorting stock, your risk is technically unlimited - if a $5 stock goes to $15, you will have lost 200% of your original investment value, a risk capped at 100% when traditionally buying stock.

The more you combine these risky strategies, the more your risk increases, it should come as no surprise.

(I did not comment on the margin-call aspect of this, which Freiheit includes in his answer. In short, if your equity drops down so significantly, you likely would need to repay your loans to your broker, whether you want to sell or not.)

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    Besides, less than 2% of "specialists" (closer to 0% actually) make long term predictions that beat the market anyway.
    – Jonast92
    Jun 15 '20 at 14:01
  • Brevity is the soul of wit. Jun 15 '20 at 14:51
  • The part about shorting was just to point out that I understand that risk (now). I also think it's obvious that N x leverage makes you lose money faster if you pick a bad time. A
    – Makotanist
    Jun 15 '20 at 15:03
-1

You are missing a very important detail about leverage. Leverage requires you not just to get the direction right but also the timing. Let's try some math:

  1. Some asset goes down 10% one week then up 12% the next week. You have no leverage. You invested $1,000. You went down to $900 then up to $1,008. You made 0.8% in two weeks. Not too shabby.

  2. You do the same thing, but with reasonable 5x leverage. So when the asset went down 10%, you went down 50%. You now have $500. But then when it went up 12%, you went up 60%. You now have $800.

Wait, what?! What happened there? How did the underlying go up 0.8% and your leveraged investment went down 20%? Isn't the leveraged investment supposed to do what the underlying does -- just more so?

It is a common misunderstanding that a leveraged investment does the same thing the underlying does, just more. That is not what a leveraged investment does. (In fact, it's mathematically impossible for it to.) Lots of people don't understand that.

How does one lose money when reasonably buying with leverage?

When you don't understand leverage, don't understand how to rebalance, and time the market badly, you can lose money when reasonably buying with leverage even if you invest in an underlying asset that goes up in value. Really.

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    In your first example the security drops 10% and then rises 12%. That's a net gain of 2%. However, in your second example, instead, it rises 10% first and then drops 12%. That's a net loss of 2%. They are different market scenarios and the comparison is invalid. Jun 15 '20 at 14:48
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    I'm sorry, but I don't follow the example. Did a margin call happen after the 50% drop? It was my understanding that, barring margin calls or panicking and selling at a loss, only the opening and closing prices matter. These get amplified by the leverage. Hence the Contract For Difference term. For the record, I also think 5x is very much the border of reasonable. In these times of volatility, even 5x seems to disappear occasionally.
    – Makotanist
    Jun 15 '20 at 15:15
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    This answer is wrong without context - the math appears to be for a leveraged ETF with daily rebalancing, which is not what OP is asking about.
    – void_ptr
    Jun 15 '20 at 15:30
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    No, with simple leverage your numbers don't make sense - if you state exposure and equity explicitly, you will see that.
    – void_ptr
    Jun 15 '20 at 15:36
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    @David Schwartz - void_ptr is correct in that this is not ETF rebalancing, it's margin exposure and you need to state exposure and equity explicitly. Assume no margin call. Buy 100 shares of $12 stock on 5:1 margin. Equity is $200, loan is $1,000. Stock drops 10% to $10.80 per share Position now worth $1,080 (60% loss of equity due to 5:1 margin), equity is $80, loan is $1,000. Position now rises 12% to $12.10 per share and is worth $1,210. Equity is $210, loan is $1,000. The net gain is the same 0.8% but the margin loss was larger due to the drop as is the margin gain from the rise. Jun 15 '20 at 16:36

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