According to Yahoo Finance, the number of Americans trading individual stocks has grown during the pandemic.
A survey the finance site conducted last fall found that 33% of people holding stock indicate that they’ve been trading more since the pandemic began. And a similar number said they’re trading individual stocks more, as opposed to ETFs and mutual funds.
This makes sense when you think of all the people cooped up at home unable to do many of their normal activities. By actively trading stocks they were actually “doing something.”
Contributing to this trend has been the market’s remarkable gains despite restrictions. Looking at this period alone, you could easily get the idea that stocks only go up.
But the Yahoo Finance poll found something else. A significant number of individual investors, 43%, said they had been using options, margin accounts, or both.
A stock option is a contract giving you the right to buy or sell a stock at a given price within a set time. You pay a fee (called a premium) to hold the contract. You lose this money if you fail to exercise the option or close the position before the option expires—that is, if the stock doesn’t move in the direction you expected.
Buying stocks with a margin account takes your risk up to another level.
Trading on margin is essentially borrowing money to purchase stocks. In theory it has the potential for a big upside. For example, if you invest $1,000 in a stock trading at $50 and it goes up to $75, your investment is now worth $1,500 and you’ve gained 50% on your principal.
But if you could borrow $1,000, add it to your initial $1,000, and make the same buy, your investment would be worth $3,000. After paying back the loan you would have a 100% gain on your principal (minus interest on the money you borrowed).
Unfortunately, predicting when an individual stock will go up is notoriously difficult. To make matters worse, the consequences for making a bad guess on margin can be quite severe.
Financial leverage cuts both ways. The multiplying effect this method has on gains also works on losses. If a stock you bought on margin drops in value, not only could you be liable for losses greater than the amount in your investing account, but these “margin calls” could automatically trigger the sale of stocks without your specific consent.
In June of this year, the Securities and Exchange Commission (SEC) issued an Investor Bulletin on the topic of margin accounts. It included basic information on how they work and extensive list of the risks.
Perhaps this was in response to the growing number of investors who are using this precarious method to chase returns.
On the other hand, prudent investors avoid over concentrating in individual stocks. They also understand that the market functions as a mechanism for efficiently distributing capital to companies who put it to work, earning a return. In general, and over the long-term, this system is the most probable way to create wealth for disciplined investors. There’s no need to try to game the system, especially with borrowed funds.