Investing with Borrowed Funds: No "Margin" for Error
With investor purchases of securities "on margin" averaging more than $406 billion for the first nine months of 2013 (a 27 percent increase over the same period last year), we are re-issuing this alert because we are concerned that many investors may underestimate the risks of trading on margin and misunderstand the operation and reason for margin calls. Investors who cannot satisfy margin calls can have large portions of their accounts liquidated under unfavorable market conditions. These liquidations can create substantial losses for investors.
Before you decide to open a margin account, make sure you understand the following risks:
This alert will explain these risks and provide you with some basic facts about purchasing securities on margin.
How Margin Accounts Work
With a margin account, you can borrow money from your brokerage firm to purchase securities. The portion of the purchase price that you must deposit is called margin and is your initial equity or value in the account. The loan from the firm is secured by the securities you purchase. If the securities you're using as collateral go down in price, your firm can issue a margin call, which is a demand that you repay all or part of the loan with cash, a deposit of securities from outside your account, or by selling some of the securities in your account.
Caution—Buying on margin amounts to getting a loan from your firm. When you buy on margin, you must repay both the amount you borrowed and interest, even if you lose money on your investment. Some brokerage firms automatically open margin accounts for investors. Make sure that you understand what type of account you are opening. If you don't want to trade on margin, choose a cash account for your transactions.
Buying on margin carries a cost. This cost is the interest you will pay on the amount you borrow until it is repaid. Margin interest rates generally vary based on the current "broker call rate" or "call money rate" and the amount you borrow. Rates also vary from firm to firm. You can find the current "call money" rate in The Wall Street Journal listed under "Money Rates." Most brokerage firms publish their current margin interest rates on their websites.
Margin Loans: Who's Profiting?
Margin loans can be highly profitable for your brokerage firm. They may also be highly profitable for your broker. Your broker may receive fees based on the amount of your margin loans. This may take the form of a percentage of the interest you pay on an ongoing basis.
The Federal Reserve Board, FINRA, and securities exchanges, including the New York Stock Exchange (NYSE), regulate margin trading. Most brokerage firms also establish their own more stringent margin requirements. This alert focuses on the requirements for purchases of marginable equity securities, which include stocks traded in the U.S. Different requirements apply to short sales, security futures, other types of securities, and certain foreign securities.
Before purchasing a security on margin, FINRA Rule 4210 requires that you deposit $2000 or 100 percent of the purchase price—whichever is less—in your account. This is called "minimum margin." If you will be day trading, you are required to deposit $25,000. To learn more about day-trading margin requirements, please read Day Trading Margin Requirements: Know the Rules.
In general, under Federal Reserve Board Regulation T, you can borrow up to 50 percent of the total purchase price of a stock for new, or initial, purchases. This is called "initial margin." Assuming you do not already have cash or other securities in your account to cover your share of the purchase price, you will receive a margin call (or "Fed call") from your firm that requires you to deposit the other 50 percent of the purchase price.
After you purchase a stock on margin, FINRA Rule 4210 supplements the requirements of Regulation T by placing "maintenance margin requirements" on your accounts. Under these rules, as a general matter, your equity in the account must not fall below 25 percent of the current market value of the securities in the account. If it does, you will receive a maintenance margin call that requires you to deposit more funds or securities in order to maintain the equity at the 25 percent level. The failure to do so may cause your firm to force the sale of—or liquidate—the securities in your account to bring the account's equity back up to the required level.
Your firm has the right to set its own margin requirements—often called "house requirements"—as long as they are higher than the margin requirements under Regulation T or the rules of FINRA and the exchanges. Some firms raise their maintenance margin requirements for certain volatile stocks or a concentrated or large position in a single stock to help ensure that there are sufficient funds in their customer accounts to cover the large swings in the price of these securities. In some cases, a firm may not even permit you to purchase or own certain securities on margin. These changes in firm policy often take effect immediately and may result in the issuance of a maintenance margin call (or "house call"). Again, if you fail to satisfy the call, your firm may liquidate a portion of your account.
For example, if you buy $100,000 of securities on Day 1, Regulation T would require you to deposit initial margin of 50 percent or $50,000 in payment for the securities. As a result, your equity in the margin account is $50,000, and you have received a margin loan of $50,000 from the firm. Assume that on Day 2 the market value of the securities falls to $60,000. Under this scenario, your margin loan from the firm would remain at $50,000, and your account equity would fall to $10,000 ($60,000 market value minus $50,000 loan amount). However, the minimum maintenance margin requirement for the account is 25 percent, meaning that your equity must not fall below $15,000 ($60,000 market value multiplied by 25 percent). Since the required equity is $15,000, you would receive a maintenance margin call for $5,000 ($15,000 less existing equity of $10,000). Because of the way the margin rules operate, if the firm liquidated securities in the account to meet the maintenance margin call, it would need to liquidate $20,000 of securities.
Margin Trading Risks
There are a number of risks that you need to consider in deciding to trade securities on margin. These include:
Do Your Margin Homework!
Where to Turn for Help
If you have a problem with your margin account that your firm did not resolve to your satisfaction, you can file a complaint online at FINRA's Investor Complaint Center.
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