Selling stocks on margin is when you sell shares that you do not actually own. How can you do that? A stockbroker buys the stock. Then they lend it to you, sell it, and deposit the value into your account. You promise to buy the stock back at some point in the future to repay the loan. This is known as short selling.
Why is your broker so nice?
First, you pay them a small fee for the transaction. You also pay the broker any dividends that the borrowed shares distribute. You hope the price of the stock will drop quickly so you can make a profit. If the stock price remains steady, you will lose the fees. If the stock price rises, you will lose the higher stock price plus the fees.
The broker ensures they receive their fees. Additionally, the broker can force you to cover the short sale at any time. This means you have to buy the stock at today’s price to return it to your broker. If the stock price is higher that day than it was on the day your broker lent it to you, you will lose the difference. The broker will only ask you to cover the short sell if there are many investors short selling your stock, and the broker needs to lend it to them! So, if this happens, the price will almost certainly be higher than the price at which you “sold.”
Big investors in the stock industry
Large investment funds use margin selling to profit during bear markets or even during stock market crashes. This is because the fund can sell the stock when its price is high and buy it back when it is low. Investment funds love margin selling because they get money upfront from selling the stock they borrowed from the broker. In fact, the only initial risk for them is the fees paid for the short sale transaction.
This leverage allows investment funds to make a lot of money when they are right. If they are wrong, they could be wrong significantly. However, fund managers generally rely on their own money, so if they are wrong, they will not pay for their mistake with their own funds. If they are right, they will receive a portion of the profit. This compensation structure rewards them for taking significant risks.
Even before the Dodd-Frank Act on Wall Street reform, investment funds were not regulated. This means they were not required to tell investors what they were doing or how much money they had lost. Essentially, investors put their money into a black box. If the fund made more profit than it lost in the long run, investors would be happy.
Advantages
Like other types of derivative instruments, margin selling allows you to achieve a high return without putting a lot of money upfront. You only need to invest the fees for your broker. If you are right and the stock price drops sharply, the remainder is all profit.
Secondly, margin selling is one of the few ways to make money in a bear stock market.
Thirdly, margin selling can hedge your investment if you already own the stock and have not sold it before the drop, believing it will just lose value. You can short sell it and profit at least from the remaining decline.
Disadvantages
You only profit when the stock price drops. If you are wrong and the price rises, you will lose the difference. The real risk is that your losses could be unlimited. If the price rises significantly, you will have to buy it at that price to return the stock to your broker. There is no limit to your loss.
Margin selling has worse effects even on the entire stock market and thus on the economy. It can take a normal decline in the stock market and turn it into a crash. If many investors or fund managers decide to short sell a particular company’s stock, they can really force the company into bankruptcy. Many experts say that margin selling contributed to the collapse of Bear Stearns in the spring of 2008, and Fannie Mae and Freddie Mac later that summer. When short traders turned towards Lehman Brothers in the fall, it was enough to spark a panic. This led to a massive collapse, signaling the crisis of 2008.
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Sources:
The Balance
Corporate Finance Institute
Source: https://www.thebalancemoney.com/short-selling-stocks-pros-and-cons-3305894
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