Advanced Diploma of Financial Planning (ADFP) Practice Test

What is a significant risk associated with margin accounts?

1. They require full payment upfront

2. They are not subject to market fluctuations

3. They can amplify both gains and losses

4. They limit growth opportunities

The correct answer is: They can amplify both gains and losses

The significant risk associated with margin accounts lies in their ability to amplify both gains and losses. When investors use margin, they are essentially borrowing funds to purchase more securities than they could with just their own capital. This leverage can lead to substantial profits if the securities increase in value, but it also means that losses can be magnified if the securities decrease in value. For instance, if an investor buys stocks worth $10,000 using $5,000 of their own money and $5,000 borrowed on margin, a 10% increase in the stock price will result in a $1,000 gain which, relative to the investor's initial $5,000 investment, translates to a 20% return. Conversely, if the stock declines by 10%, the loss of $1,000 against the initial investment results in a 20% loss as well. This ability to create substantial gains or significant losses highlights the inherent risk of trading on margin. In contrast, a margin account does not require full payment upfront; it involves the use of borrowed funds. They are also still subject to market fluctuations, which is a fundamental aspect of investing. Lastly, margin accounts can actually enhance growth opportunities rather than limit them, allowing investors to purchase more securities