Margin trading and short-selling have been controversial topics in the stock market, so much so that academics have invested years of research to understand how these two affect the stock market. From liquidity to market volatility, margin trading can be both positive and negative to the stock market.
WHAT IS MARGIN TRADING?
Margin trading is, in layman’s terms, when an investor borrows cash to use to invest in stock. It is when you, as an investor, borrow money from a broker to invest in a stock. The idea behind margin trading is that the prices of the stock will increase in the nearest future. Therefore, to make more profit from future price increase, an investor borrows from a broker. But the “borrowing”, which is called the margin, is done only after the investor has put down some money.
HISTORICAL EFFECTS OF MARGIN TRADING
There is no general consensus on how margin trading and short selling affects the stock market, or any financial market for that matter. But historical data shows that margin trading might have been responsible for the great stock crash of 1929. The theory, which is backed by data, is that brokers gave too much leverage to investors, who in turn took very risky bets on the market. Now, when the market wasn’t going as planned, instead of brokers closing in on investors and counting their losses, they lent more money to investors. In the end, brokers and investors lost as many, seeing the market was headed for the pits, and sold their stocks cheap.
The belief that stock prices will continue to rise is called the pyramid effect, and it was responsible for investors’ margin trading recklessly prior to the great crash.
Before delving into the impacts that margin trading has on the stock market, it is imperative to understand the pros and cons of margin trading, whether it’s in the stock market or the cryptocurrency market.
ADVANTAGES OF MARGIN TRADING
While the literature on margin trading has focused more on its deleterious effects on the stock market, there are advantages of taking “loans” to buy stock. These advantages affect both individual investors and the stock market.
For investors, margin trading helps them to do the following:
- Increases the investors buying power
- Helps investors diversify their portfolio
On the stock market, margin trading is advantageous because it:
- Increases market liquidity
- Increases market volatility in emerging markets
DISADVANTAGES OF MARGIN TRADING
The downside of margin trading for investors and day traders on the stock exchange is that:
- It increases their exposure level, thereby increasing their risks.
- The margin loan interest charges can be so high if stock prices go against you, the investor
HOW “BORROWING TO INVEST” CAN AFFECT THE STOCK MARKET NEGATIVELY
The recent slump in the prices of stocks, crypto and other financial securities has piqued financial experts worldwide. There is a belief that margin trading, especially in unregulated and mildly regulated markets, negatively impacts the stock market. In this year alone, the stock market has liquidated $10 trillion of investors and traders’ money, while the crypto market has liquidated $1.7 trillion. While this isn’t a comparison on which financial market is riskier, it only shows how volatile the market currently is.
Figure 2: Co-Movement
Source: Song, In-Man & Douthett, Edward & Jung, Koyool. (2003). The Role of accounting information in stock market Liberalization: Evidence from Korea
Margin trading, from historical research, does not have a defined impact on the stock market; it depends on the size of the market and the regulatory laws in place for margin trading. For example, India, in 2010, set down strict guidelines on margin trading. The two guidelines are:
- Before a stock can be margin traded, it must have reached a certain trading frequency
- The average impact cost of a stock can’t exceed 1%
With guidelines such as these, margin trading can increase the market’s liquidity as the leverage effect of margin trading will increase the supply and demand of stocks.
However, when traders become over excited in the stock market, taking trading at high margins, and brokers, in a bid to make more money, not caring for leverages, there is a high possibility of a co-movement, a situation where the prices of most stock fall at the same time, then the stock market will be the worse for it.
So, while there are no hard and fast rules to the effect of margin trading and short selling, an unregulated margin trading market will lead to market crash, and by extension wipe out trillions of investors’ money in the stock market.