If you’re new to investing, you may be wondering if it’s possible to lose more money than you invest in stocks. The answer seems like it should be a straightforward – no. After all, if I invest $500 in a stock, how is it possible to lose more than what I put in? But as with most things in life, the answer isn’t so simple.
Fortunately, you’ve come to the right spot. In this article, I’ll explain how, yes, it’s possible to lose more money than you invest in stocks. But it comes with a few caveats, so be sure to read to the end to avoid becoming a victim of the market!
What is margin trading?
One of the caveats making it possible to lose more money than you invest in stocks is margin trading (also known as trading on margin).
Margin trading allows investors to borrow shares and/or borrow money to buy and sell “marginable” securities (stocks, exchange-traded funds, and commodities).
But why would someone want to borrow shares or borrow money? The answer is threefold:
- To short stocks on a bearish bet the price will go down
- To increase buying power by borrowing money (known as a margin loan) from your broker
- To trade stock options
A margin account is required to do all 3 of these things. And virtually anyone can get approved to trade on margin.
Long vs short positions
In the stock market, there are 2 basic ways to make money. The first, and most traditional, is by opening up a long position (also known as going long). A long position is when an investor buys (to open) a stock at a lower price than they intend to sell it (to close). In other words, the investor hopes the price of the stock goes up.
For example, if an investor opens a long position at $100, they’re hoping the share price goes to $110, leaving them with $10 in profit per share.
The second way to make money in the stock market, which new investors may be less familiar with, is when an investor opens up a short position (also known as going short). A short position is when an investor sells (to open) a stock they do not own in hopes of buying it back (to close) at a lower price in the future. In a short sale, the investor profits when the stock price falls.
For example, an investor could sell a share at $100, then buy it back at $90, leaving them with $10 in profit per share.
Here’s the most important thing to remember:
- When going long, the most an investor can lose is the amount invested. While the profit is unlimited.
- When going short, the most an investor can profit is the amount invested. While the loss is unlimited.
Let me explain why.
Loss potential on short positions
If I took up a long position (buy to open) in a stock, purchasing 1 share at $100, the worst case scenario is if the stock goes to $0. In such a case, the most I can lose is $100. So my loss is capped at the amount invested.
Now, consider if I took up a short position, selling (to open) 1 share at $100. The best case scenario is if the stock goes to $0, where I can buy (to close) the position for $100 profit (100%). After all, a stock can’t go below zero, so the most I can make is 100%.
But what happens if the stock goes to $200, $500, or even $1,000, before I close the position?
- At $200, my loss is $100 or 100%
- At $500, my loss is $400 or 400%
- At $1,000, my loss is $900 or 900%
As you can see, even though I only invested $100 in the stock, my loss potential is, theoretically, unlimited. This is why short positions are considered riskier than long positions.
The lowest a stock can go is $0, but the highest it can go is infinity.
Margin increases loss potential
While it’s true that the most I can lose in a long position is the amount invested, what happens if I bought shares on margin (i.e. using borrowed money)?
Let’s say I purchased 100 shares of a stock at $50 for a total of $5,000. I purchased 25 shares or $2,500 using my own money. But the remaining $2,500 I purchased on margin. What happens if the stock price drops from $50 to $25 or $20?
- If the stock price drops to $25, the total investment is worth $2,500. So I’m down 100% or $2,500 on the money I invested.
- If the stock price drops to $20, the total investment is worth $2,000. So I’m down 120% or $3,000, and owe the broker $500 (margin call).
As you can see, trading on margin amplifies losses, making it possible to lose more money than you invest…even in a long position.
This same phenomenon happens when shorting stocks on margin, which is even riskier due to the unlimited loss potential when going short.
What is a margin call?
Yes, brokerages like TD Ameritrade (my review here) and Interactive Brokers allow investors to borrow money to invest in the market. Fortunately, most brokerages have safeguards in place to keep losses to a minimum. After all, brokerages don’t want you to lose all their money either.
So, if you get yourself into a pinch while investing on margin, your broker may step in to protect their investment. This may include a requirement to deposit more funds to maintain your maintenance requirement. Or closing your positions without your consent if a trade goes against you.
It’s possible that, even after closing your positions, you still owe the brokerage money. This results in a margin call, which is a summons for you to repay any borrowed money lost and/or to deposit more funds.
A margin call is never a situation you want to find yourself in.
Bottom line
Yes, it’s possible to lose more money than you invest in stocks. But you can avoid such a fate by never shorting stocks and never trading on margin.
Sometimes you’ll want to bet against the bull market by going short, or buy stocks on margin to amplify your gains. But buyer (or seller) beware, as this can be risky business if not executed properly. Be sure you understand what you’re getting into before you’re already in it.
If you stick to the traditional practice of using your hard earned money to buy low and sell high, you can never lose more than you invest in stocks.
