The Robinhood app has exploded in popularity over the last several months. An influx of new investors flocked to the zero-commission service while markets tumbled in February and March, and many correctly bought into stocks as a market recovery took hold.
This type of early trading success can sometimes foster boldness, and occasionally even arrogance, among these new investors. I know, because I was the same way when starting out years ago. There are mistakes new investors can avoid to limit the tragic downside to trading that inevitably comes when bad times cycle back, without putting too low a ceiling on potential positive returns. Here are two prime examples of trading mistakes that Robinhood investors should make efforts to avoid.
1. Say no to margin
For the Robinhood app and many of its competitors, buying stock on margin is now just a few clicks away. While this is wildly tempting for some, it's a slippery and dangerous slope to take. Borrowing money as part of your trading process makes your room for error picking stocks much smaller.
Brokers require investors to maintain a certain amount of capital (called maintenance margin) in any margin account. If you fall short of a designated minimum, brokers will either require you to come up with the needed funds or force you to sell some positions (likely at a loss) to account for the margin change. As an investment performs poorly, you become more and more vulnerable to falling below that precarious threshold.
Having to liquidate stocks to cover a margin call means no capital gains whenever a position finally appreciates or pays a dividend. It also limits flexibility. With full investment and no cash reserves, there is no ability to average into a position and lower a cost basis. This is a great way to enhance profits over time.
There are a meaningful number of investors who have taken on haunting debt loads because of margin. This can erode a person's credit score, which means higher interest payments on any debt in the future. If you want a house, for example, the loans needed will be much more expensive to pay off. Tread with caution when borrowing on margin. It is a dangerous temptation capable of crushing your bank account and more.
2. Avoid speculating with options
Speculating with short-dated options is yet another mistake most Robinhood investors should avoid. Trying to guess the upcoming moves of stock markets is immensely difficult. Timing them to occur in just the next few weeks is even tougher.
Let's take Moderna, for example. The stock for this pharmaceutical company more than doubled in July due to promising coronavirus vaccine news (and it was promising). Last week, the stock price fell 15% with no company-specific news. Why? Because a competing inoculation from Pfizer showed promise. That's all it took. This was entirely out of Moderna's control and still led to a sharp price decline.
Derivative option traders who stayed bullish on Moderna thinking the company's own vaccine news would keep propelling it higher lost a fortune from the Pfizer headline risk. When you trade options, you have to be right about the direction of the stock. You also have to be right about when that price movement will occur. The company may very well reach higher highs in the future. Equity holders will benefit, but those options expiring this week or next will most likely not.
Options are generally meant to be used for hedging stock trades, not speculating. If a position is performing especially well or poorly, using puts and calls can be an effective way to limit exposure and downside. When contracts are instead used to guess the next move in a stock, the odds are not in your favor.
Stock markets are an exciting vehicle for building wealth over time. When too much risk is taken -- with margin, options, etc. -- investing can quickly turn into a cash-burning activity, especially for those who tend to be less experienced with stock trading. I stay away from margin and options speculation. Perhaps you should, too.