Personal Finance & Money Asked on February 22, 2021
I have a stock brokerage account, and I want to make sure that the things I do in it will not cause me to be liable for more than the amount I put into the brokerage account. My question is: under what circumstances will I be liable for more than the value in the account?
From what little knowledge I have, I believe that these situations could cause losses in excess of the cash I put into the account:
For example, suppose my account has $2000 in cash, and I short 100 shares of a $10 stock. If the stock rises to $45 in a short time span, my stop-loss order could be ineffective. My broker would close out the position, leaving me with a -$1500 balance. This is a situation I do not want, because it requires me to pay $1500 in excess of what I had in my account.
Besides those instruments I listed above (which I really want to avoid), are there any other instruments I should avoid in order to keep potential losses within the value of the account?
To avoid the risk of losses in excess of the value in the account, I currently use a basic cash account (non-margin account with no ability to buy or sell options). However, I will soon be moving to a margin account with the ability to trade futures and options. I need to move away from the cash account because I want to sell covered call options (which I know is safe). I don’t want to make it possible to lose my house just because I "accidentally" bought a very risky financial instrument with unlimited downside, so I need to know what these risky instruments are in order to avoid them when I get a margin account.
I need to move away from the cash account because I want to sell covered call options
Covered calls are allowed in cash accounts because they are safe -- if not at your broker, consider trying another. So your question may be moot if this is all you need. But proceeding anyway...
Let's distinguish the two different questions: "unlimited liability" vs. "liable for more than the amount I put into the brokerage account".
Unlimited liability would be a position that can theoretically go down by any amount to minus infinity. This would be an unhedged short position (plain short or naked call, as you note) on an underlying such as a stock or stock index (which is inherently nonnegative but can go up by any amount), or any unhedged position (long or short) in a futures contract on a physical commodity (these can go negative, as seen recently with oil).
Liability for more than you put in can occur even when the liability is limited. It occurs whenever you borrow money for an investment (the classical purpose of a margin account), e.g., a long stock position with leverage. If the stock crashes faster than your broker can liquidate it, you can end up owing. Similarly for a naked put. (This does not apply to achieving leverage via a leveraged ETF or a long option, which is why those can be used in cash accounts.)
There is a classic story of indebtedness resulting from buying stock on margin in the 2000 bubble:
As I sit tonight - I have no shares of Celera in my account and an account that was worth almost $60,000 and was full of 6 promising, fantastic stocks is now worth $0.
In fact, it's worth less - I must send $1,500 to the broker.
Answered by nanoman on February 22, 2021
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