Margin Accounts

How Does Margin Work?

“Margin” refers to the practice of borrowing funds from one’s broker or investment adviser to purchase a security, with that security itself used as collateral in the transaction. There are many advantages to purchasing securities on margin, chiefly the increase of purchasing power that allows investors to buy more securities without completely paying for them. There are also many risks, chiefly the increase in potential for significant losses. Below are a few key points about buying on margin.

Margin: the Basics

When you purchase securities on margin, your broker lends you funds to pay for them. A $50,000 margin account, for instance, can be used to purchase $100,000 worth of securities. That second $50,000 is loaned by your firm.

If you purchase a stock for $500 and the price of that stock increases to $750, you’ve just earned a 50% return on your investment—provided you fully paid for it using a cash account. If you purchased that stock on margin, using $250 in cash and borrowing $250 from your broker, then you’ve earned a $100% return on investment—though you do owe your broker $250, as well as interest.

So, the benefit of a margin account is that it can effectively double your gains on an investment. Naturally, borrowing on margin also doubles the risk. Not only does it put you at risk of losing more than your investment if the security depreciates, but it also requires you to repay the firm’s loan, plus interest.

When markets are particularly volatile, investors who make margin purchases may occasionally need to provide additional funds if the stock price falls. Investors may be surprised to learn after the fact that their firm had the right to sell securities that were purchased on margin, even without notifying the investor. This is known as a margin call. In such cases, investors lose the opportunity to recover their losses if the market picks back up.

Understand the Risks

Margin accounts are not suitable for all investors. Before investing on margin, consider these four key risks:

1)    You may lose more money than you initially invest
2)    You may be required to provide additional funds on short notice
3)    You may be required to sell some or all of your securities if falling prices depreciate their value
4)    Your brokerage firm may have the right to sell some or all of your securities without consulting or notifying you

Your broker is required to obtain your signed authorization before opening a margin account, so be sure to thoroughly read the margin agreement—paying special attention to how the loan interest is calculated—before signing.

Know the Margin Rules

FINRA, the Federal Reserve Board, and other entities have many rules pertaining to margin trading. For instance, FINRA requires any investor trading on margin to first make a minimum deposit of $2,000 or 100% of the purchase price—whichever is smaller. Additionally, the Federal Reserve Board has stipulated that investors may only borrow as much as 50% of the purchase price of margin securities, though some firms may require that investors deposit more.

To learn more about margin trading, read FINRA’s Investor Alert on the topic or contact the attorneys at Fitapelli Kurta.