What Does Margin Trading Do to the Economy?

What Does Margin Trading Do to the Economy?
source: todaysecommerce.com

Trading on margin by investors can have a direct impact on the economy. Of course, credit is the fuel that powers the economy, and the credit cycle is an important factor in determining the direction the economy is headed in.

How does credit fuel the economy?

When credit is considered a driver of the economy, many entities are considered. Companies, individuals, and even the government take part in the credit cycle. For example, when the government borrows in order to invest in programs, that impacts the overall economy.

Borrowing is not necessarily bad. On an individual level, homeownership to the level it occurs in the American economy would not be possible without people taking on debt. For businesses, borrowing money can help buy equipment or other resources that help companies to grow. The government can also use debt in productive ways, such as when it invests in infrastructure projects.

When it comes to business endeavors, prudent borrowing can actually elevate a company’s stock value as investors can see that the management team is vested in the long-term future of the firm.

Margin trading

Another form of credit that may seem invisible but that has an impact on the economy is margin trading. According to the experts at SoFi, “Margin trading, or buying on margin, means to buy on credit. Or, to borrow funds to pay for an investment in order to buy more of an asset than you’d otherwise be able to.” Both options, which create artificial leverage and margin accounts, have a direct impact on the stock market.

When investors think a particular stock is about to rise or fall, they can buy on margin or use options. They hope to amplify their returns by doing this. In essence, they are borrowing money in order to invest in the stock.

If they make a good call, they stand to reap great rewards. However, if they made the wrong call, then they could lose more than 100% of their investment. That makes this strategy very risky.

Depending on how leveraged the market is, the stock market as a whole and even the broader economy could be impacted by these types of investment strategies. When a large group of investors is heavily leveraged, if the rug is pulled out from under them, then there may be a wave of margin calls and defaults. All of a sudden, what would have been a slight decline in the overall market can become a bloodbath as investors fight to cover their losses.

This is what caused the collapse of Archegos. A fund that heavily used leverage, it was forced to unwind all of its assets in order to cover margin calls. And it’s not alone. Margin debt is a quickly growing portion of the investment sector.

In fact, there are worries that sufficient margin debt could lead to an overall collapse of the market as a whole and therefore affect the wider economy. This is particularly true after an overly optimistic period in which stocks have been going up consistently for a while. Investors can get overconfident, and this can lead to disaster. When margin debt approaches high levels, then investors should prepare for the worst-case scenario.

To learn more about margin trading as well as many other investment terms and strategies, check out SoFi. The well-written articles on the site provide a wealth of information to help you make wiser investment choices.

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