The main reason to borrow money to buy securities is for financial leverage. Financial leverage can increase the rate of return for an investment, if it is profitable, but it also increases potential losses. Because of the potential for greater losses, traders become more emotional in their trading decisions, which may cause excessive trading, which increases transaction costs, and it may cause bad trades when emotion overrules reason. Furthermore, the longer the money is borrowed, the greater the amount of margin interest that must be paid, so using margin for buy-and-hold strategies is generally not a good idea.
Another major disadvantage to using margin is that the trader potentially loses some control over the account. If purchased stock drops too much, the broker has the right to sell the stock before notifying the customer. For a short sale, the broker may be forced to buy back the securities in an illiquid market, if the lender wants the securities back.
If the margin ratio increases because purchased securities have increased in value or because shorted securities have decreased in value, then the trader gains excess margin that can be used to purchase or short additional securities. Continually using excess margin to increase investments is called pyramiding.
While pyramiding may work for a while, at some point, the equity of the account is going to decline, because stocks don’t continually increase in value nor do shorted stocks continually decline in value. Therefore, eventually there will be a margin call. Hence, the use of margin should be restricted to short-term trades.
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