Compare the mechanics and investment implications of buying

Compare the mechanics and investment implications of buying on margin and short-selling. Be sure to detail and provide examples ot illustrate how margin trades magnify both the upside potential and the downside risk of an investment portfolio?

Solution

Margin is a type of leverage that allows investors to post only a portion of the value of the security they purchase. As such, when the price of the security rises or falls, the gain or loss represents a much higher percentage, relative to the actual money invested. A margin trade can magnify upside potential and downside risk of an investment portfolio because it allows an investor to invest in an amount greater than their ownmoney will allow. By having this greater amount of capital, they can achieve a greater upside potential if the value of the stock rises. However, it is also extremely risky because the investor takes on a great risk of having to pay back the principal and the interest borrowed if the stock price were to decrease past the point of receiving a return.

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