7 Common Risks Associated With Stock Trading That You Should Know
Stock trading is the process of taking advantage of changes in stock prices to buy and sell with the aim of making a profit. NOTE: Capital is at risk with any investment
Due to the increase in the number of retail brokers & the growth in mobile investing, stock trading has become more popular & there are now many regulated platforms which let you day trade stocks as CFDs, which is done without actually owning the stock or you can also trade stocks via other derivative instruments.
CFDs aka contract for difference are a big reason many trade stocks because the burden of delivery and ownership of stock is removed. You bet on if the price of the stock will rise or fall and the P&L is settled in cash, hence you can get carried away at this ease, and be careless.
But there are still risks involved in trading stocks, and stock indices which may not be evident to you in the beginning, and we will be looking at them. Let’s discuss them in detail.
Stock Buy-In Risk
Buy-in risk is tied to a trading strategy called short selling. A short seller is one who borrows shares from a broker, sells them at the current market price, waits for the price to fall, then buys them back at a cheaper price and returns to the broker.
As a short seller, during the period you are waiting for the share price to fall so you can re-buy it, the owner of the shares might ask for his shares back. If you refuse to return the shares, he can go and buy the shares from someone else and you will have to refund the difference he spent buying those shares to him. This is called stock buy-in.
Stock buy-in can be risky for you as a short seller because the owner of the shares might go and buy from elsewhere at a higher price thus you end up paying him that high price difference.
But it is important to note that this risk is for short sellers who borrow stock for selling & not for CFD traders as you don’t actually own any stock with CFDs.
Short Squeeze Risk
A short squeeze is a sudden rise in the prices of stocks thereby having a ‘squeeze’ effect on short sellers. This means that short sellers have to cover their position.
A short squeeze can occur when there’s unexpected bullish news predicting the rise in stock prices or it can even occur in cases of low volume ‘meme stocks’ which can result in heavy losses for the short sellers.
When the prices eventually go up, short sellers like you are forced to buy back the stocks at a higher price than what you sold them for. This way, you have made losses instead of profits.
Short selling aims to make a profit from the fall in stock prices but if the price shoots up suddenly, then you make a loss if you close your position at that high price.
Dividend Risk
Firstly, you are faced with dividend risk as a short seller dealing in dividend-paying stocks. If you short a stock that pays dividends, you still must pay the dividend to your broker if you purchase stocks before the ex-dividend date.
This is because you borrowed the stock from your broker, so, any benefit gotten from the stock has to go to the owner of that stock. Before you short-sell stocks, you should pay attention to the ex-dividend date. This is the date that cuts off new share buyers from dividend benefits for the last financial year.
If you buy shares after an ex-dividend date, you will get paid dividends for the coming financial year, not the past financial year.
For instance, you borrow £1,000 of Company A shares from your broker before the ex-dividend date. If the dividend is 20%, you owe your broker £200 alongside any other cost associated with the contract.
Secondly, you can also encounter dividend ‘risk of early assignment’ if you trade stock options. Assume you sell a ‘call’ option on TSLA stock that gives the option holder the right to buy 100 TSLA shares from you, at $100 per share, one month from now (expiry date).
If a few days to expiry the price of TSLA rises to $101, the option holder stands to make $100 if he executes his American-styled contract now. This is because, unlike European-styled options, American option contracts can be executed before expiry.
Now if the option holder hears news that TSLA is going to pay a dividend of $2 per share after his contract expires, he can choose to exercise his contract immediately after he hears this news. This is because by doing so, he can buy the shares from you at a lower price of $100 per share and you must also pay him the dividend of $2 per share.
The takeaway here is the ex-dividend date is the date after which even if you buy new shares you don’t qualify for that financial year’s dividend payment. The option holder executes his contract a few days before the ex-dividend date so you also pay him the dividend as he buys the shares from you.
Liquidity Risk
Liquidity refers to how quickly assets can be bought or sold in the market. When an asset is liquid, it means it can easily be converted to cash. For illiquid assets, it is difficult to get a counterparty.
You can measure liquidity risk by the bid-ask spread or width. A small bid-ask spread shows that the market is liquid. Depth of Market is also used to calculate market liquidity. The higher the number of orders for the stock, the more ‘deep’ and liquid the market is.
Trading stock is normally done on margin, which is borrowing money from your broker to trade. The longer you spend waiting for a counterparty, the more margin loan interest you pay. You could be stuck in a position if there is no counter party for your order.
Margin Risk
Margin enables you to trade using leverage that is, borrowing funds to increase order size, and generate higher profits.
Although margin can increase profit if you are correct, you are faced with a greater loss should the trade go against you. Margin and leverage have an inverse relationship
When your position is opened, you need an amount of money to keep it afloat, which is known as the margin level. It is usually expressed in percentages. The Financial Conduct Authority (FCA) has set margin close out rule for CFDs and CFD- like options to 50%.
This means that when your margin level falls below 50% while trading stock CFDs your broker will close all your open positions at a loss without recourse to you.
Example
Assume you have a $5,000 account balance aka equity in your margin trading account and you select a leverage of 1:30 (this is an example, but the real leverage for stock CFDs is lower) this means for you to open an order of say $50,000 you must deposit an initial margin of (1/30 x 50,000) = $1,666 while your broker borrows you the remainder of $48,334. This means your initial margin requirement is 3%
The $48,334 is a loan on which you pay interest for as many nights that you keep your buy position open.
Your Margin level = (Equity/used margin) x 100% = ($5,000 / $1,666) x 100%= 300%
If you record a loss as small as 5% you lose $2,500 which slashes down your equity $2,500. Take note a 5% loss has wiped your equity in half because you used a high leverage of 30:1. The higher the leverage ratio you use, the faster your account equity gets depleted.
FCA margin close out rule is set at 50% margin level, so if you keep opening new orders and they end in losses, your equity keeps reducing and it will get to a point where your margin level falls to 50% and you are closed out of the market by your broker resulting in heavy losses.
Stock Trading Can Be Suspended
Trading activities on a stock or security can be paused briefly on one or more exchanges. When this occurs, it is called a stock halt or trading halt. A trading halt can either be regulatory or non-regulatory.
Trading halts could occur due to the following:
- If the stock doesn’t meet the requirements of the exchange.
- Vital news about the company’s products and services.
- Mergers, acquisitions, or restructuring of a company.
- Excessive buy or sell orders of stock.
- The stock gets delisted from the exchange
For example in 2021, GameStop (GME), a video games retailer, recorded a rapid rise in its stock price. The Securities and Exchange Commission (SEC) stated that it was monitoring the market volatility.
A few hours after that, Robin Hood, a zero commission broker, issued a trading halt on GameStop. Robin Hood received several attacks from its users online stating that the trading halt put them at disadvantage. This shows a broker can halt trading of a stock if they believe they are acting in the interest of the greater good.
Regulatory Risk
Regulatory risk is a risk faced by a company as a result of changes in the law, policies, or regulations guiding them. New laws can affect the operations and profitability of a company positively or negatively.
Regulation changes can even hinder a company from doing business. Companies have to abide by rules stated by their regulatory authorities.
Also, there can be rules against short selling which can prevent the short sellers to make money from falling markets.
Balancing Risk & Reward
Stock trading doesn’t go without some risks involved whether you own the stocks or not. The use of margin and leverage which is administered via CFD contracts makes it riskier. Always use minimum leverage and don’t be greedy.
During high market volatility, you can choose not to trade because volatility increases risk. No position is still a position. Always research a stock and use risk management tools like stop loss orders to limit your losses when you trade stock.
*Disclosure: This article is for entertainment and educational purposes only. Nothing on this site constitutes financial advice. I am not a financial advisor. You should always do your own research and consult a qualified financial advisor before making big decisions with your money as capital is at risk with any investment. This post may contain links to external sites and affiliates, Savvy Dad accepts no responsibility for how you use these external sites and services (see Site Terms and Privacy Policy).
