Many Chinese investors learned last week how leverage can magnify gains -- and losses

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The use of leverage can both magnify gains and losses, something many Chinese investors found out last week following a 13.3% plunge on China’s benchmark Shanghai Composite index.

Not only did stocks suffer their largest weekly decline in percentage terms since June 2008, those stocks that carried the greatest level of margin positions heading into last week’s market rout fell by an even greater amount.

According to a report from Bloomberg, the 30 stocks in Shanghai with the highest level of margin debt relative to tradable shares have fallen by 17% since the index hit a multi-year high of 5,178 back on June 12.

In a margin trade, investors use their own money for just a portion of the stock purchase, borrowing the rest from a brokerage. The loans are backed by the investors’ equity holdings, meaning they may be compelled to sell to repay their debt when prices fall, or add additional capital to bring their margin position back to an acceptable internal risk level with their broker.

Given stocks carrying the highest level of leverage declined by a greater amount than the broader index, along with news that overall levels of margin debt fell for the first time in a month last Friday, it suggests that many investors, instead of adding additional capital, were forced to liquidate their losing positions.

The question now is what will happen when China’s stock market opens up today following a holiday on Monday. Anyone watching the price action closely last Friday would know that stocks tumbled into the close. While leveraged investors unwinding losing positions likely contributed to the slide, it’s also likely many did not have the time to cut their positions, or did not receive margin calls during market hours.

If this is the case it suggests that further losses, stemming from investors being forced to unwind losing positions upon the market open, could continue today.

According to Bloomberg, there is still “at least $364 billion of borrowed money riding on stocks in Shanghai and Shenzhen”. If the losses continue to mount the likelihood of further margin calls and further forced selling will feed upon itself.

The Shanghai Composite will resume trading at 11.30am (AEST).

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