Succinctly, margin is a deposited sum that serves as security for an account or transaction. It is collateral that covers credit risk which arises from borrowed funds, financial instruments sold short or derivative contracts entered into by an investor.
Brokers and advisors recommend margin because it can be extremely profitable, as investors borrow money from the firm to purchase securities. In some cases, brokers may use margin without the knowledge or authorization of client, or in their zeal to maximize firm profit, they may over-utilize the practice at the expense of the consumer.
Before you consider investing in or purchasing securities on margin, here are some key facts, put out by the Financial Industry Regulatory Authority (FINRA), that you should know:
FINRA Investor Alert: Investing with Borrowed Funds: No "Margin" for Error
Not surprisingly, buying on margin accounts—wherein you borrow cash from your broker with which to invest—is essentially equivalent to taking out a loan with your brokerage firm serving as a bank or finance company.
Since margin is a loan, interest is charged on the loan. The interest rates, also known as broker call or call money rates, charged vary from firm to firm. The interest rates may also be dependent on the amount you borrow, such that your rates may be lower if you borrow more, in an attempt to convince investors to spend more.
FINRA, the Federal Reserve Board, New York Stock Exchange (NYSE) and other securities governing bodies regulate margin trading so as to protect consumers against unethical or illicit practices.
For instance, FINRA requires a minimum $2,000 deposit in your account. In lieu of $2,000, this minimum margin may also be satisfied by a deposit of 100 percent of the purchase price. Day traders are required to deposit $25,000.
The Federal Reserve Board maximizes the borrowing amount at 50 percent of the total purchase price of new stocks. This is also known as initial margin.
FINRA additionally requires a minimum maintenance margin of 25 percent of your securities' current market value. At all times, equity must be maintained at 25 percent so as to protect the consumer from being overwhelmed by margin debt. Failure to maintain 25 percent equity may result in a maintenance margin call to produce this minimum and may result in the firm liquidating securities to meet this goal.
Firms may additionally impose house requirements, which must be equal to or more stringent than FINRA and Fed provisions.
FINRA Rule 4210 and Federal Reserve Regulation T are the governing documents that deal with various margin provisions, such as minimum, initial and maintenance requirements.
Because of the nature of margin trading, additional risks result from the possibility of sudden securities liquidation to meet the requirements of a margin call. Firms have the authority to sell securities without notifying investors or giving investors the opportunity to choose , t which securities or assets to sell. In addition, a brokerage firm has the ability to increase house requirements for any reason at any time and without advance notification (which could subject investors to margin calls and put them at risk of securities liquidation). Altogether, this means investors stand to suffer great financial loss in a margin account, and even potentially lose more money than was initially deposited.
In the end, buying on margin can be incredibly risky just as it can prove fruitful. For this reason, it is especially vital to thoroughly research the various aspects related to margin trading and the unique dangers involved in purchasing securities with borrowed funds. Because of its profitability for firms, investors should consider the true nature of a broker's recommendation to open a margin account: such advice may be legitimate, but may also be misleading.
If you believe you were inappropriately advised to open a margin account, were coerced into relying too heavily on margin, or a broker has used margin without your authorization or knowledge, please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for an investigation and consultation.