There is a lot of confusion about the risks of investments and if investing can put you in debt. Many people think that if they invest in stocks or options, they can only make money. This is not true!
There are also risks of losing money when you invest. In this blog post, we will discuss some of the risks associated with different types of investments.
Can you owe money when investing?
Yes, it's possible to owe money when investing. This can happen in a few different ways: through naked options, margin calls and shorting.
Can you lose more than you invest?
It depends on the investment style you use. It is possible to lose more than you invest through using debt with the tools mentioned above. If you invest your own money by simply buying a stock or asset at the market price, without using debt, the most you can lose is your initial investment.
Learning how to evaluate undervalued stocks, and using stop losses can also help to prevent a loss of your initial investment. A stop loss is when you sell a security at a predetermined price, to prevent further losses if the stock falls in value.
For example, if you bought a share at $100 and have a stop loss at $95, your investment will automatically sell at $95, causing only a 5% loss.
If you are not comfortable with losing your initial investment, ETFs (exchange-traded funds) or index funds may be a better option for you.
What happens if my investment goes negative?
If you lose money on an investment, you can owe money to the broker if you use margin. When you use a margin account your broker provides you capital to trade and charges interest on it. This is what is commonly described as leverage. It allows you to increase your profits, but it can also put you in a tough position if you happen to lose money.
If the value of your investment portfolio drops below a certain threshold you will get a margin call.
The broker can require that you repay the negative balance. They can even sell your investments without your consent to recover their funds.
If you lose all of the money you invested, you can owe money to the broker. If you fail to pay your broker, you can be sued, and your broker might take possession of your home, car, or other assets. You can end up in bankruptcy.
This is why you should extremely careful when trading, especially if you are using margin.
Can investing put you in debt?
It can, and often does. When you invest in stocks or options without using margin (i.e., borrowing money from your broker to buy), you can only lose the principal amount.
However, if you use margin, short stocks, or sell naked options (i.e., without owning the underlying asset), you can lose more than your investment and owe money to your broker.
For example, if you buy a stock for $100 and it falls to $0, you can lose no more than your initial $100 investment. But if you buy the same stock on margin for $50 and it falls to $0, you can owe your broker the remaining $50.
Credit card and personal loan debt
You can find yourself in a bad situation using the broker tools mentioned above. But other forms of debt can come from taking on too much risk with your investments. Credit card debt and personal loan debt can easily spiral out of control if you're not careful.
For example, if you use a credit card to invest in stocks, and the stock market takes a nosedive, you can easily find yourself owing more money on your credit card than the initial investment you put in.
This can happen with other types of loans as well, so it's important to be mindful of how much debt you're taking on, and be sure that any investments you make can cover potential losses.
Margin can multiply gains or losses
How can margin multiply gains or losses? Let's say you buy $1000 worth of stock on margin and the stock rises to $2000. You can sell the stock for a $1000 profit, but you can also borrow another $1000 from your broker to buy more of the same stock.
If that stock then falls to $0, you can lose all of your initial investment plus the additional $1000 you borrowed from your broker. In this case, you can owe your broker $2000.
This is why margin is a double-edged sword, and using it while investing can put you in debt.
While investing can help you build wealth, it can also be risky. Without the proper research and understanding of how certain investments work, you can lose more than you invest.
Keep reading as we will discuss in more detail the three situations where your brokerage account can go into negative balance: naked options trading, margin calls, and short selling.
Risks of selling naked options
A naked option is when you can sell an option without owning the underlying asset. In other words, it's like selling a promise to buy or sell something at a future date, and at a predetermined price.
The seller can make money if they can make money if the price of the underlying asset moves in the direction predicted.
But what happens if the market changes too much from now till expiration?
A worst-case scenario can be that the price of the underlying asset moves against you.
If you sell 1 call option contract at a $100 strike price, you are essentially receiving the option premium to give the buyer the possibility of buying 100 shares at the agreed price. If you do not own the 100 shares and the price moves above $100, the buyer of the call option can exercise the option. This means that you will have to give the buyer the 100 shares, that are now trading over $100. You will end up losing the premium and the difference between the current price and the strike price, plus the broker fees.
The same thing can happen if you sell a put option.
This is a big risk because it can be hard to predict what will happen with market stocks and options in the future.
Losing 100% of your investment is a bad situation but can naked options put you into debt? Yes, naked options can put you into debt, especially if you do not know what you are doing.
Margin debt can lead to a margin call
A margin call is when you owe your broker more money than you have in your account. This can happen if the market takes a turn for the worse and your stocks lose value.
For example, if you buy $1000 worth of stock on 50% margin and the value falls to $500, the broker can ask you to pay the remaining $500. If you don’t have that money in your account, then the broker can sell the stock to cover the debt.
This can happen with other types of investments. So it's important to be mindful of how much margin debt you're taking on.
Risks of getting a margin call
Another thing to keep in mind is the risk of margin calls. When you buy stocks on margin, you're essentially borrowing money from your broker to invest. This can be a great way to maximize your profits, but it can also lead to big losses if your stocks drop in price.
A margin call is when your broker demands that you deposit more money to cover the margin loan, or else sell some of your stocks to pay it back. If you can't come up with the cash, you can have your securities sold at a loss.
There are plenty of great reasons to invest in stocks and options, but it's important to be aware of the risks involved.
Make sure you understand how margin trading works before you start, and be prepared for the possibility of losing more than you can afford to lose.
Risks of shorting a stock or asset
Shorting an asset or stock means that you are borrowing an asset or stock to sell short. When you close your short you need to return the shares you borrowed.
When an investor shorts a stock, they can profit if the price of that stock goes down in value. However, there is substantial risk involved when investors short a stock or asset because prices can also go up and lead to potentially unlimited losses.
When you buy a stock and it goes to 0, all you can lose is your initial investment. However, when you sell short a stock, the stock can go higher, and higher. Creating a situation where you can lose a lot more than your initial investment.
Shorting and margin
Shorting requires you to have a margin account because your broker will be lending you the shares you want to short.
An investor can lose more than their initial investment if the security does not decrease in value as much as was expected since your broker will be charging interest on the amount borrowed.
For example, let’s say someone borrows $100,000 from their brokerage firm for a short position against Company A shares at $50 per share. On paper, this company can buy 2000 shares of Company A at $50 per share. If the price goes down to $25 as expected, they can sell those 2000 shares for a profit of $100,000.
However, if the price rises unexpectedly and then falls back down to only $30 per share instead (still an unexpected drop), it can lead to heavy losses because they can only sell those two thousand shares for sixty thousand dollars ($30 x 2000) which is less than what was borrowed from their broker.
In this case, the investor would owe their broker forty-thousand dollars in addition to losing any initial investment made upfront before borrowing money on margin.
Margin calls can also occur when there are significant losses which means that a brokerage firm can demand more money to be put into the account to maintain the margin position.
Avoid margin calls at all cost
This is why investors need to understand how much can be lost when shorting a stock. They should make sure they can afford any potential margin calls that may come up. It's also worth noting that naked options can lead to even more debt. If the trade goes wrong so it's crucial for traders using this strategy to be very aware of all risks involved.
Shorting stocks is not the only way that some people have gotten into debt through investing, however it can certainly happen quickly when using margin calls or naked options. Using margin while investing can put you in debt, so it should be avoided except in special situations and depending on your experience.
Can you owe money to Robinhood?
Robinhood does not provide negative balance protection. The most you can lose on a cash account is 100% of your initial investment.
Robinhood does offer two other accounts where there is potential for you to owe money to the company if your trade goes wrong. These two accounts allow for margin trading and the risks associated with it:
- Robinhood Instant
- Robinhood Gold
If you borrow money from Robinhood (or any other broker) to invest, you can receive a margin call if the value of your investments falls below a certain threshold. If you can't repay the money you owe, the broker can sell your investments to recover their costs.
So, can investing put you in debt? The answer is yes, but there are ways to minimize these risks by knowing what to watch out for.
Robinhood is an easy platform to use and is accessible to the general public. This is great to get more people investing but there are risks. Robinhood has faced bad publicity as uneducated traders began using the margin accounts and ending up in debt.
Debt can be a very dangerous thing when it comes to investing. It's important to make sure you understand the risks before using any of these tools.
Robinhood can also be set up to automatically sell assets before they can become too much of a risk which can help prevent losses from spiraling out of control if something unexpected happens like an asset price going down drastically overnight due to bad news.
Using naked options, margins, and shorting can be effective ways of making money in the markets, but they come with their risks. If you do not have any experience trading it is better to focus on teaching yourself about these concepts before jumping into trading.
These trade tools are better suited for more advanced and experienced traders. Using them while investing can put you in debt.
If you are comfortable with the potential of debt, it may be an effective strategy for you. As an active trader or passive investor, save this article and return when you are deciding if using debt/leverage in the markets is right for you.
Image source: Unsplash
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