Can You Lose More Money than You Invest in Stocks?
The stock market is a bit complicated when it comes to investments and stuff. You have a lot of assets and options to choose from. You can invest in equity, you can invest in futures and options, you can invest in derivatives etc. Now all of these investment options come with different conditions and stipulations. Some investments make you liable only for the amount that you own and have invested but in other cases, you also risk having to pay extra from your pocket or more money than you planned on investing. So to answer the question: can you lose more money than you invest in stocks, we say yes. How? Let us understand.
Losing Money in Cash Accounts
You have the option of opening a cash account or a margin account. Cash accounts are those accounts in which you deposit as much money as you are okay with investing and potentially losing. In this type of account, you can’t borrow money from the broker and are only able to invest the sum that you have deposited in your account. Let’s say you have transferred 4,000 dollars to your account, this means now you can only use this money and buy stocks worth 4,000 dollars. A settlement cycle takes place here, when you buy a share it takes two business days for the transaction cycle to complete where the money is paid, and then the stock ownership is transferred to you. Now, these stocks that you own can be worth 100 dollars each one moment and 0 the next. Although highly unrealistic, let’s say that they happen to touch a valuation of zero rupees. In this case, you lose all your invested money. But that’s the end of your loss, nothing more to pay or owed to anyone.
Pros of Cash account
The biggest and best advantage of the cash account has to be the fact that you can’t lose a penny more than you have invested. Your risk is defined by you and you are liable just for that much amount. You also get the flexibility and option of choosing your investment cap. You can set it as high or as low as you want. Lastly, you can hold the stocks for as long as you want. Until the share value goes to zero you can keep holding the stock regardless of whatever price movement is occurring.
Cons of Cash account
It takes two days for a trade to settle. These two business days see you buying or selling stock and then the whole transaction of money going through takes place which is when finally the trade is complete. You also can go ahead with short selling in a cash account. If you think the price of a share is going to go down then the option of short selling can come in real handy but that benefit is not available to cash account holders. Lastly, unsettled funds can be used to trade in stocks but they violate the act of good faith and more than a few of these transactions can see you being left with the option of only being able to trade with settled funds.
Losing Money in Margin Accounts
With margin accounts, you have the power to borrow funds from the brokerage to invest in a stock. The Federal Reserve Board Regulation T allows you to borrow as much as 50% of the purchase price. However, here since the money is borrowed you are now liable to pay back the money as well as interest on it. So let’s say that you purchase stock worth 4,000 dollars of which half of the funds are borrowed. Now let’s say the stock value doubles up to 8,000 dollars in valuation. This leaves you with 2,000 dollars to repay plus the interest which still leaves you with a huge sum of profit. On the other hand, let’s say the stock value comes down to 2,000 dollars. This leaves you with 2,000 dollars only which is the amount you owe to the broker. Once you pay that back you still owe them the interest on borrowing which will see you pay more from your pocket. So can you lose more money than you invest in stocks? In this case yes.
Pros of Margin account
Trading through a margin account gives you more purchasing power while also reducing the cash-in-hand requirements significantly. You can opt to invest more funds than you have which might benefit you hugely. You can see yourself pocket amounts so huge in so little time which might not be possible with a cash account even after a whole year. Lastly, you can make money from the rising price of a stock or its falling price. You can short-sell the stock and still make money from a share that performs badly which is advantageous and only possible with a margin account.
Cons of Margin account
As you can earn more with this account does not mean that is it, on the other side of the picture you can also lose more than the sum invested. You owe the broker the borrowed funds and the interest which might see you pay much more than your initial investment. Also since there is a rate of interest on the borrowed funds they dictate the profit you make. A big interest rate means a big dent in the profits even after taking all that risk yourself. Here you have borrowed funds to trade so you must pay it back no matter how the stock performs and you are not just paying back the borrowed funds but also the interest on it. Lastly, you must sell some of your securities as there is a provision in place that forces you to keep some liquidity or balance in your account as the price of the stock falls. Also Read: Is Real Estate Investment Trusts a Good Career Path?
If my Stock goes down do I owe money?
It is not a straightforward question and nor is the answer to it straightforward. Ideally, the money you invest in stocks is the total amount that you are liable for. However, there is more than one type of investor in the market, and they all employ different techniques of investment which is what makes it possible answer to this question: if my stock goes down do I owe money, being yes. If we talk about a short sale the seller borrows stocks or money to buy it from a broker or a dealer who has a sell order. You here must buy the stock in the future and are hoping for the price of the stock to go down. Let’s say you choose to short 400 shares for 10 dollars each. This leaves you with shares worth 4,000 dollars. Now if the price of these shares falls to 1 dollar then you would owe 400 shares to your lender. This would mean you pay 400 dollars and get to bag 3,600 dollars as profit. On the other hand, if these shares start performing well and see their price increase then you might be in deep trouble as the loss might have no upper cap. If the shares doubled to 20 dollars then you would have to subtract the original price of the stock, that is, 10 dollars, and multiply the remaining 10 dollars with the number of shares, that is, 400. This means you now owe the lender 4,000 dollars. This price can go further up and increase your losses until you cut your losses by paying the amount owed. Here again the answer to the question: can you lose more money than you invest in stocks, will be a resounding yes.
Leveraging a purchase
Another risky situation might occur when you opt to leverage a purchase. Here, you borrow money to increase your investment amount which allows you to go for higher profit but you can also end up making higher losses. Let’s say you have 4,000 dollars and borrow 4,000 more this leaves you with an amount of 8,000 dollars. Now you invest this 8,000 in shares and are liable to pay 500 dollars each year as interest. Assuming the share jumps to a value of 10,000 in the next year you are now liable to pay a total of 4,500 dollars which leaves you with 5,500 dollars of which 1,500 is your profit. On the other side of the spectrum let’s say the share is now worth just 6,000 dollars. In this case, you now owe the lender 4,500 dollars again and here you are left with 1,500 dollars while incurring a loss of 2,500 dollars. In situations like this can you lose more money than you invest in stocks? Well, there are rules and regulations in place to prevent it from happening but it still might happen that you lose more than you invest if you don’t make the right decision at the right time and cut your losses. Let us now learn what happens if stock price goes to zero.
What happens if stock price goes to zero?
So we have seen the scenarios above where you can lose more money than you invest in stocks but what happens if stock price goes to zero? When you are paying more than you invested the stock is still there on the market and its price hasn’t hit zero. It is just you who has made a loss on your transaction. Also when it comes to you losing all your money in a stock it comes down to your investment decisions but when that does happen what is the road ahead? Do you get back any money or are you in the negative?
How do losses occur?
In the stock market, equity shareholders are not the only investors. There are bondholders, banks, preference shareholders, and other parties that are ahead of them in the line for repayment in case of bankruptcy. Shares usually work on demand-supply and the profitability of the company, however, when the company starts performing badly and making losses the share heads toward downfall which is when investors see their investment value fall sharply. You either exit during such stages and cut your losses if you get the chance or you see the share value hit zero and the company gets delisted. In this case, you wait and hope that the people ahead of you in line get paid and there is still something left for you as well. Now let’s say the share value is zero and you didn’t get paid after the company’s asset sale wasn’t enough to pay everyone, what now? Again you have managed to escape without further losses with your maximum loss being equal to the amount of investment made by you initially. But can you lose more money than you invest in stocks in such a situation? For an equity investor, the answer is no. Their loss is just the 100% amount of investment or limited to the amount at which they were able to exit the company. But if you were invested in a long or short position then a different fortune awaits you. If you were holding a long position then you were betting on the stock value appreciating and since the stock is now worth zero you have made a loss of 100% as opposed to someone holding a short position who estimated the fall in the price of the stock. They are the ones who have made a 100% profit at this stage. So here you could end up earning much more than invested as opposed to achieving a neutral figure of 0 and a 100% loss in the case of equity.
Case on Enron
Enron is a real-life example of a company whose stock went valueless. However, a company that is going bankrupt can renegotiate its debt and restructure the company or ask for more finance from the public. Even if that doesn’t work they can try selling their shares over the counter or sell shares for more than zero where the investors invest in it hoping for a miracle comeback by the company. Now you know what happens if stock price goes to zero. Also Read: 11 Best Penny Stocks Under 10 Cents
Long trade vs Short trade
So we know about equity and holding stocks and we also know the answer to what happens if stock price goes to zero. But what exactly is short and long when it comes to trading? These are the two trading methods where the answer to if my stock goes down do I owe money, will be yes. Going long means owning stock from which you will benefit if its price goes up. On the other hand, going short means borrowing stocks and betting on their prices to go down, which is when you have to buy these shares. So in this game of profits and losses which one is the better option for you? Let’s look at the pros and cons of both these methods of trading to determine which one is better for you.
Advantages of Going Long
Going long means you deal in a stock where you buy it at a lower price and sell it for a higher price to make a profit which is the way most traders trade. This kind of trading gives you an ownership stake in the business which brings with it certain provisions and benefits. Here you would make money when the stock price goes up and lose money when the price of the stock falls but can you lose more money than you invest in stocks? Absolutely, no. Also, you need to have the funds to be able to go long or you may borrow money. You don’t pay any fees to own a stock and you can also receive cash dividends on a stock by going long.
Drawbacks of Going Long
In case you borrow money to invest in stocks then you have to pay a rate of interest for it which cut your profit and in case of loss, you still have money that you need to pay back.
Advantages of Going Short
The nicest benefit of going short is that you benefit from it when the stock value falls instead of going up which makes it a unique way of trading.
Drawbacks of going short
If you are going short you are not getting any kind of ownership rights or power in the company whose stock you own. Since the stock prices can keep going up your potential loss has no cap on it which means you either cut your losses soon or see yourself fall down the liability hole. However, you need to have a margin account to be able to go short and you also pay interest on the borrowed sum as well as other expenses which eat into your profits. The dividends given on short stock are deducted from your account and handed over to the owner of the shares. Hopefully, you now have the answer to can you lose more money than you invest in stocks? And what happens if stock price goes to zero? There are many types of investors and they all have different strategies. You need to do your research and develop your own techniques so that you invest confidently without any fear.
