Margin Trading: Managing Risks

Some common-sense strategies that one can use to mitigate the inherent risks of margin trading:

Avoid being leveraged to the hilt

You may have the ability to take on a significant amount of margin debt and the unshakeable conviction that your trading ideas will work, but even so, do not leverage yourself to the max. Leave yourself some breathing room in case your trades go against you, as they often will.

Use margin only for short-term, opportunistic trading

Margin trading is not conducive to a long-term, buy-and-hold strategy because the interest cost on margin debt can add up to a substantial amount over time and make a major dent in your profits. You might be better off using your margin account for short-term, opportunistic trading where you need some leverage.   

Use margin for a diversified portfolio

Using margin for a basket of stocks or a diversified exchange-traded fund reduces the odds of a margin call being triggered by a major decline in one stock. If you have a large margined position in a single stock, you are vulnerable to a margin call because any number of events can trigger a big decline in the stock – an earnings miss, an adverse development in the company’s prospects, regulatory change, a drop in the overall market, and so on. (Related: The Importance Of Diversification)

Risk management

When you use margin, it may be prudent to develop a risk management plan in case things go awry. This means closely monitoring your investments and staying on top of market developments that may affect them. For example, be aware of release dates for important economic data that can move the markets. Run stress tests to determine what your losses might be in an adverse scenario, and decide your strategy beforehand. Will you cut your losses or will you inject additional margin in the account?  It might be advisable to have a margin account at the same broker where you hold the rest of your investments in order to transfer funds expeditiously in the event of a margin call. (Related: Risk Management Techniques For Active Traders)

Be prepared to take losses

Think like a trader and accept losses as an inevitable byproduct of trading. This means exiting your position even it means taking a small loss, rather than holding on in the hope that the stock will turn around, and watching your losses spiral out of control.