Yes, you can lose more money than you invest in the stock market — here’s how

This can happen in two different ways, although one is more likely than the other.

Quick answer: There are two ways you can lose more money than you invest. The first is by shorting stocks, while the second is by buying stocks on margin. However, the chances of losing a lot more than you invest by buying stocks on margin are low due to the restrictions imposed by brokers — more details below.

Yes, you can lose more than you invest in stocks, ETFs, and other financial instruments, but only if you are a risky investor. 

Before we get into the nitty-gritty, let’s get an important thing out of the way. Most brokers offer two account types: a cash account and a margin account. With a cash account, you’re only trading with your own money — the money you deposit into your account. In this case, you can never lose more money than you invest.

Also read: The best investing audiobooks to get

For example, let’s say you have $5,000 in your account and buy $5,000 worth of shares of a company called XYZ, with each share being priced at $100. If the company goes bankrupt, making its stock price drop from $100 to $0, you’d lose your entire investment of $5,000. You can’t lose more because the stock can only drop to zero and can’t go negative.

What about margin accounts?

Things are a bit different if you have a margin account, though. With a margin account, you can borrow money from your broker to buy stocks. For example, you can buy $5,000 worth of stocks by putting up $2,500 of your own money and borrowing $2,500 from your broker.

A margin account also lets you short stocks, which basically means you are betting that a stock will go down in value as opposed to up. You can learn more about this concept in our dedicated “Why is shorting stocks risky” post at the link.

It’s these two things — borrowing money and shorting stocks — that can make you lose more money than you invest. Of the two, shorting stocks is riskier.

Shorting stocks is risky

As already mentioned, an investor who shorts a stock will make money if the stock price declines. Here’s how it works: The shares of a company called XYZ are trading at $100, and your plan is to go short. The first step is to borrow the stock on the market from another investor (or your broker) and then sell it right away, which will put $100 in your pocket. After the stock’s price drops to, let’s say, $80, you buy the stock back and return it to its owner.

So you sold the stock for $100 and bought it back for $80, meaning you are left with a $20 profit before trading and other fees.

Read next: How much money do I need to start investing

Now let’s say that you are wrong and that the stock price goes up instead of down. So, for example, the price jumps from $100 to $150. If you buy back the stock, you’ll pay more for it than what you initially sold it for, which means you’re losing money. In this example, this would be $50, not including trading and other fees.

But here’s the deal: There’s technically no limit as to how high the stock price goes. As an example, let’s say that the price jumps from $100 to $1,000. If you buy back the stock, you’ll lose $900 — 9x more than your initial investment of $100.  That’s the reason why going short on a stock is riskier than going long (buying and hoping the stock’s price increases), as shorting can lose you a lot more money than you invest.

Using leverage is risky as well

In addition to shorting, using margin to buy stock — even if you go long — can technically lose you more money than you invest, although the risk here is not as high as with shorting due to various safety measures used by brokers.

Let’s use the same example of a company called XYZ whose shares are trading at $100 each. You buy $10,000 worth of shares, but you only put up $5,000 of your own money while borrowing the other $5,000 from your broker.

Read next: The most expensive stocks in the US

Let’s say that the stock price drops from $100 to $50. This is a 50% drop that would decrease your account balance by $5,000, which is the amount of money you put up for the trade. If the stock would go to zero, you would lose $10,000, but since you only put up $5,000, you now owe $5,000 to your broker.

However, your broker will place a margin call before your part of the investment ($5,000 in this case) gets wiped out, asking you to either sell off the position at a loss or deposit additional money into your account. If you don’t comply, the broker will close out the position for you to protect its capital — the $5,000 it loaned you — and to make sure you won’t lose more money than you invested. If a margin call wouldn’t be issued, you could potentially lose all the money you borrowed from your broker, and your own as well.

There you have it — these are the two ways you can lose more money than you invest in the stock market, with shorting being the one that’s more likely to happen. To prevent going down this road, opt for a cash account, so you’ll always trade just with your own money.

Mitja Rutnik

Mitja has more than a decade of experience working as a journalist and has written for various publications in North America and Europe. In addition to all things finance, he loves sports and is a self-proclaimed pizza expert.

Leave a Reply

Your email address will not be published.