Why is leverage (debt) trading dangerous in falling market?
Wed, Jan 10, 2018 6:00 AM on Latest, Exclusive, Featured, NEPSE News, Others, Stock Market,
Leverage trading can be as fun as sounds of tinkling coins in a casino while as dangerous as conversion of a safest blue chip shares into a risk.
Leverage or debt trading is the process where investors borrow money in order to buy stocks of the companies. However, in between this process, obligation such as interest rate payment is attached to the investors. The objective of a rational investor who gets into leverage trading is to profit more than the principal and interest rate amount on loan. Leverage trading is also called margin trading.
One can use debt trading either by applying for share loans in BFIs or taking credits in the brokerage firm. The brokerage house borrows money at a certain rate and charges a slightly higher rate to the investors. This rate is still objectively cheaper. Thus, the brokerage house will float funds to the investors in order to facilitate them with the purchase of shares. Although margin loan system from brokerage house has started with SEBON’s green signal, NEPSE is yet to publish its final guidelines.
As investors apply for debt, certain personal assurances are taken in collateral by the lender in case of bankruptcy of the investors.
In context of a falling market, the share prices of companies decline. It is uncertain when the market will show a green index. As an investor borrows certain amount for trading, it might occur that the market takes a long period of time to recover. In such cases, the investor might bear a greater extent of loss and hence, debt trading can be risky.
Besides, the interest obligation of investor might exceed the profit from the trade, and thus, investors might face loss. For instance, an investor buys 100 shares of a company at Rs 800 each. However, the market takes an upward trend only after several months. The share is now priced at Rs 850 however; the interest payment has exceeded way more than the profit i.e. Rs 50 per share. Thus, the debt trading can be risky to investors.
The investors may not always see the dark side of debt trading. There are times when they make huge profit from such trading. Warren Buffet stated: "when leverage works, it magnifies your gains; your spouse thinks you're clever, and your neighbors get envious", but the other side of the story is that “leverage is addictive”. Investors usually get excited as they earn profit from leverage trading. This is exactly when gambler’s fallacy occurs. The investors take in too much risk after a luck win and thus, they are likely to incur high chances of loss.
Besides, it is often seen that the banking and stock market is interrelated. So, as the stock market is in the falling trend, the banking industry usually has higher loan interest rate. Those investors who apply for share loan, thus, might incur higher cost in terms of increasing interest rates. When investors consider loan amount for investing, they need to consider the interest rate charged by lending institutions and historical market return. The 10 years of average yearly NEPSE return is around 15.6%. Thus, if the interest rate is higher than the market return, it would be wise enough to avoid share loans for a certain period of time.
However, a few strategies might come in hand to protect one from the risks of leverage trading. Investors must buy safe value investment if they use leverage trading. The investors must be able to analyze the compensation as per his/her economic status. The investors should also avoid mental accounting while using leverage trading. Investors should use the loan amount for trading instead of long run investment. Thus, debt trading might suit a bullish market.
The falling market usually does not favor the investor’s interest. The risk avert investors can thus avoid share debts in the bearish market. Thus, investors are urged to play safe as you never know when a debt trader might become a gambler.
(Disclaimer: Any kind of information that is provided in the article should not be used as a sole advice or recommendation by investors in order to design their investment portfolio. So, before taking steps for any kind of the information, the investors are required to base their judgment on their own financial analysis, appropriateness of the information and seek independent financial advice. The information of the company has been taken from the authorized sources such as website of the company, NEPSE and financial reports of the company so, any changes not updated in these may differ in the analysis.)
In context of a falling market, the share prices of companies decline. It is uncertain when the market will show a green index. As an investor borrows certain amount for trading, it might occur that the market takes a long period of time to recover. In such cases, the investor might bear a greater extent of loss and hence, debt trading can be risky.
Besides, the interest obligation of investor might exceed the profit from the trade, and thus, investors might face loss. For instance, an investor buys 100 shares of a company at Rs 800 each. However, the market takes an upward trend only after several months. The share is now priced at Rs 850 however; the interest payment has exceeded way more than the profit i.e. Rs 50 per share. Thus, the debt trading can be risky to investors.
The investors may not always see the dark side of debt trading. There are times when they make huge profit from such trading. Warren Buffet stated: "when leverage works, it magnifies your gains; your spouse thinks you're clever, and your neighbors get envious", but the other side of the story is that “leverage is addictive”. Investors usually get excited as they earn profit from leverage trading. This is exactly when gambler’s fallacy occurs. The investors take in too much risk after a luck win and thus, they are likely to incur high chances of loss.
Besides, it is often seen that the banking and stock market is interrelated. So, as the stock market is in the falling trend, the banking industry usually has higher loan interest rate. Those investors who apply for share loan, thus, might incur higher cost in terms of increasing interest rates. When investors consider loan amount for investing, they need to consider the interest rate charged by lending institutions and historical market return. The 10 years of average yearly NEPSE return is around 15.6%. Thus, if the interest rate is higher than the market return, it would be wise enough to avoid share loans for a certain period of time.
However, a few strategies might come in hand to protect one from the risks of leverage trading. Investors must buy safe value investment if they use leverage trading. The investors must be able to analyze the compensation as per his/her economic status. The investors should also avoid mental accounting while using leverage trading. Investors should use the loan amount for trading instead of long run investment. Thus, debt trading might suit a bullish market.
The falling market usually does not favor the investor’s interest. The risk avert investors can thus avoid share debts in the bearish market. Thus, investors are urged to play safe as you never know when a debt trader might become a gambler.
(Disclaimer: Any kind of information that is provided in the article should not be used as a sole advice or recommendation by investors in order to design their investment portfolio. So, before taking steps for any kind of the information, the investors are required to base their judgment on their own financial analysis, appropriateness of the information and seek independent financial advice. The information of the company has been taken from the authorized sources such as website of the company, NEPSE and financial reports of the company so, any changes not updated in these may differ in the analysis.)
