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The Risks of Margin and Leverage — Forced Liquidation and Margin Calls

'Invest with other people's money and your return doubles' — that's half true. The other half is 'losses double too, sometimes beyond your principal.' History has proven this many times.

What Is Leverage

Leverage is using debt (margin, deposit, loans) to run an amount larger than your own money. As the word (a lever) suggests, you move large assets with small equity.

For example, if you use 2x leverage on about $740, you run about $1,480 worth. If the asset rises 10%, that's about a $148 gain (+20% relative to your own money); if it falls 10%, that's about a $148 loss (-20%).

In other words, leverage magnifies your loss rate just as much as your return rate. The problem is that when losses grow, forced mechanisms called 'margin calls' and 'forced liquidation' kick in.

Margin Calls and Forced Liquidation

When the price of an asset bought with debt falls, its collateral value shrinks. When collateral drops below a certain level, the brokerage demands additional margin — this is a margin call.

If you can't come up with the money within the set deadline, the brokerage forcibly sells the asset regardless of your wishes. This is forced liquidation.

Forced liquidation usually happens at 'the worst time' — in a crashing market. Because you are forcibly sold near a crashed bottom, the loss is locked in and the debt sometimes grows larger than the principal. Losing even the chance to wait for a recovery is the scariest part of leverage.

History (1) 1929 — The Tragedy of 10% Margin

Just before the 1929 Great Depression, buying on margin — putting up only 10% of a stock's price and borrowing 90% — was rampant in the United States. If the stock rose 10% your principal doubled, but if it fell 10% you lost your entire principal.

When the bubble burst, forced liquidation begot forced liquidation. The Dow fell about 89% from its peak, hitting 41.22 points in the summer of 1932, the lowest of the 20th century.

When a market inflated by leverage collapsed, debt made the decline deeper and faster.

The '10% margin (90% borrowing) buying on margin was rampant' and 'the Dow fell about 89% from its peak (41.22 in the summer of 1932)' for 1929 were cross-checked against multiple sources including Federal Reserve History, AARP, and the Bill of Rights Institute.

History (2) 2021 Archegos — A Collapse in 4 Days

Even in modern times, the danger of leverage repeats. In March 2021, the family fund Archegos used enormous leverage through derivatives, and when its holdings plunged about 30% in 4 days, it could not meet margin calls.

Banks hastily force-liquidated about $20 billion worth to recover collateral, and in the process the banks themselves took large losses. Credit Suisse lost about $5.5 billion (the most), Nomura about $2.87 billion, and Morgan Stanley about $911 million, with total bank losses reaching about $10 billion.

Leverage is dangerous enough to spread one investor's failure into losses at multiple financial institutions.

Archegos's 'plunge of about 30% over 4 days' and 'Credit Suisse about $5.5 billion, Nomura about $2.87 billion, Morgan Stanley about $911 million, totaling about $10 billion' were cross-checked against The TRADE, Al Jazeera, Investing.com, and others. Bank-by-bank loss tallies differ somewhat by source and point in time.

よくある質問

Q. Can leverage make losses larger than the principal?

Yes, it can. When you invest with debt, losses can exceed your equity if the asset price falls sharply. If you are force-liquidated, that loss is locked in and you can end up having to repay the remaining debt. It is fundamentally different in the nature of its risk from an ordinary purchase, where 'you only lose the money you put in.'

Q. Do leveraged ETFs carry the same risk?

Leveraged ETFs have no margin-call or forced-liquidation risk, but because of the structure that resets the multiple daily, they have a 'volatility decay' problem where long-term performance gets eaten away in a volatile market. It is a different mechanism from directly borrowing on margin, but the essence — 'leverage magnifies losses' — is the same.