The reason lies in the psychology of the margin call.
Most investors when faced with market adversity will refuse to cut their losses and will continue to meet margin calls until their capital is depleted. It is human nature for most investors to hide or cover up mistakes. After all, an investor thinks that if he cuts his losses, his friends and family may laugh at or ridicule him. So to avoid this scenario of disgrace or loss of face, the investor will put in more margin, hoping the market will turn for the better.
Because the investor is trading on the emotion of hope rather than reason and careful analysis, the loss usually gets bigger. Remember there is a reason the share is getting cheaper. What gets cheaper is likely to get cheaper still.
On the other hand, a professional trader will routinely cut his losses with no emotions. A professional will almost never meet a margin call. A professional will be out long before his equity suffers a 50% drop. Edward Toppel, a prominent S & P floor trader in Chicago wrote an interesting book on emotional control, entitled Zen in the Markets.
"The right thing is to get rid of your losers immediately. The ego will produce the most fantastic reasons for holding on to the money-draining positions be it stocks or futures. Ego will fight us all the way and prevent us from realising quickly that it is better to swallow our pride and do the right thing and that it is to take the loss before it becomes expensive."
For those who do not cut their losses or meet the margin call, the broker will force-sell their shares. If the shares continue to decline, there will be more margin calls. At some point, the investor will run out of money. This is the market's way of enforcing the discipline of cutting losses.
When the lending institution force-sells an investor's shares, the selling may depress an already weak market almost guaranteeing the worst possible price. If the value drops below the initial equity during the forced sale, the lending institution may file a lawsuit against the investor to collect the over-loss. If the investor cannot pay, the lending institution has the right to seize the investor's assets, including his house and business.
If you find yourself in this position, the best policy as Edward Toppel would say is to immediately cut your losses and try to salvage whatever money left. Almost any experienced trader or investor will tell you, never add more margin to a losing position. This is the same as throwing good money for bad.
Frankly, margin financing is a strategy, which should only be used by sophisticated professional traders who have risk management strategies in place. Without a strategy to close your position should the market collapse, you are gambling - not investing. If you wish to gamble, go to the casino, you will get better odds. There is no free lunch and beware because the lure of windfall profits is the bait to snare the ignorant and greedy player. There are great risks and high costs in margin financing. If you do not understand the risks and costs you should seek professional advice.
There are other financial institutions offering share-financing facilities, some offering up to five times the collateral, although specific conditions apply. You should use extreme caution before considering their offers and understand perfectly the risks and costs involved. |
