Most Americans who invest in the stock market work with stockbrokers or financial advisers to build an investment portfolio. There are a number of benefits to working with a broker, including the ability to take advantage of their financial acumen to grow your nest egg.
Unfortunately, there are situations where financial advisers don’t act in your best interests. This can be case with margin trading, a specialized type of investment strategy that can amplify gains – and losses. Too often, brokers push customers towards margin trading because it is incredibly profitable for them, even if it isn’t suitable for that particular investor.
For the average individual investor, there are few faster ways to lose nearly all of your assets than through large-scale participation in margin trading. If you have lost a significant amount of money due to margin trading performed without your consent or without a full explanation of the risks, you may be able to recover the funds that you lost with the help of a stockbroker misconduct attorney.
What Is Margin Trading?
Margin trading is a way to buy stocks with someone else’s money. Specifically, “margin” refers to an investor borrowing money from their brokerage firm and using that money to either invest or spend as the investor sees fit. We’ll discuss using the margin funds to invest here. Using margin funds to invest offers the potential for higher returns on an investment but carries substantial risk.
Trading on margin is a way to increase your buying power as an investor. With a cash account, you must pay the full amount for the securities that you purchase. A margin account is a type of brokerage account that allows you to use the account itself as collateral to borrow money from your broker-dealer, which funds can then be used to purchase stocks.
The way that it works is relatively straightforward. Consider a situation where you purchase a stock for $100, and the stock price rises to $150. If you bought the stock using a cash account, then you will earn a 50% return on your investment ($50 is 50% of your original investment of $100). However, if you bought the stock on margin, paying $50 in cash and borrowing $50 from your broker, then you will earn a 100% earn on the money that you invested ($50 on $50, minus any interest rate charged on the amount borrowed).
Of course, not every stock bought on margin will increase in price. If the stock drops in value, then your losses will be magnified in the same way. Using the example above, a $100 stock that drops to $50 in value represents a 50% loss in a cash account — and a 100% loss in a margin account, plus interest on the $50 loan. In this way, losses in margin trading can add up quickly.
Margin trading is governed by rules established by the Federal Reserve Board, the Securities Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). These rules principally work to protect the brokerage firm, not the investor.
- Minimum Margin: FINRA requires investors to deposit a minimum of $2,000, or 100% of the purchase price of the securities before trading on margin, whichever is less. Some brokerage firms may have higher minimum initial investment amounts.
- Initial Margin: under Regulation T of the Federal Reserve Board, investors may borrow up to 50% of the purchase price of equity securities on margin. As with minimum margins, some brokerages may require a deposit of more than 50% of the initial purchase price.
- Maintenance Margin: FINRA requires firms to impose a maintenance requirement on margin accounts, which is the minimum amount of equity that must be maintained in a margin account at all times. This account balance is determined by subtracting the amount owed to the brokerage firm from the value of the securities in the margin account. Under FINRA rules, the maintenance margin must be set at least 25% of the total value of the securities purchased on margin (margin securities), but brokerage firms may set a higher threshold.
- Pattern Day Trader Margins: customers who are “pattern day traders” must have a special margin requirement on their accounts, with an increased minimum equity requirement and a restriction on purchasing to four times the maintenance margin excess.
Any investor who is considering trading on margin should learn these rules as well as other regulations governing margin trading.
Understanding The Margin Call
If the value of the collateral in your brokerage account falls below the required margin threshold, then the firm may issue what is known as a margin call. This requires you to immediately deposit additional cash or securities to boost the account value above the maintenance margin. Significantly, a brokerage firm can change this threshold at any time.
For those investors unable to bolster the collateral by depositing cash or securities, a sale of the existing securities will be required to meet the margin call. A person who has made long-term investments may suffer significant losses in liquidating them to meet the margin call – especially since the margin call likely came during a market downturn, requiring the investor to sell their securities at lower prices.
Even worse, a brokerage firm can sell the securities in a margin account, and may not even be required to consult you before doing so. The brokerage firm can decide which securities to sell, and may even sell securities before letting you know of the margin call’s existence or giving you an opportunity to cover the shortfall in your margin account. Under most margin agreements, a firm can sell your securities without waiting for you to meet the margin call and you have no right to control which stocks will be sold or when they will be sold.
Under almost all circumstances, if the brokerage firm acted in a commercially reasonable manner as it exercised its rights under the margin contract, the investor will have no opportunity to recoup their losses, even if and when the stock market bounces back. When interest charges on the loan and commissions are added, a customer can be looking at large — or even total — losses. Investors who borrow heavily and flirt with the margin thresholds are often wiped out in a market downturn – even if that downturn lasted only a matter of hours.
The Risks and Benefits of Margin Trading
Excessive margin trading is not appropriate for every investor. Brokers and their firms, however, profit well on the margin debt thanks to the interest charged. Thanks to the handy profits margin debt provide to the firms, financial advisers/brokers may recommend the strategy, even in situations where trading on margin is not suitable for the customer.
The main advantage of margin trading is the potential to reap much higher returns on investment, particularly in comparison to trading using a cash account. However, there are significant disadvantages to margin trading, including:
- Losing more money than you invested;
- Having to deposit additional cash or securities in your margin account on short notice to cover stock market losses;
- A brokerage firm selling some or all of your securities to pay off a margin loan, and having no control over which securities are sold or when they are sold;
- Having to sell off some or all of your securities when the value of the securities in your margin account decreases;
- A brokerage firm increasing its margin requirement at any time, thereby changing your risk; and,
- Not being entitled to an extension of time to meet a margin call.
Before opening a margin account, it is important to read the margin agreement that governs it. You should also research and understand how margin debt can affect your investments and long-term financial health. Make sure that you understand the margin interest rates charged by your broker, and how that may affect the total return on your investment.
Margin trading is not for everyone. If you are considering it, ask your broker whether trading on margin is appropriate for you based on your financial goals, resources, and risk tolerance. A responsible broker will evaluate the suitability of margin trading based on your unique situation and will make a recommendation accordingly.
Unfortunately, there are situations where customers who do not understand margin trading, and who should not be engaging in it, are persuaded by stockbrokers to open margin accounts. These customers may assume that margin accounts work like conventional loans, where they can pay back what they borrow over time. They are often unaware that in contrast to defaulting on a mortgage, their liability can be sudden, immediate, and beyond their ability to control.
If a broker or brokerage firm was trading on margin without your authorization or knowledge, or if they failed to explain the risks of excessive margin trading, you may be able to take action against them to recover your investment losses. When brokers engage in unsuitable or excessive margin trading, it can often lead to financial devastation to unwary clients. In these situations, you may be able to recover your money through medication, FINRA arbitration, or another avenue, such as securities litigation.
Trusted Excessive Use of Margin Trading Attorneys
Stockbrokers can make a lot of money on margin trading, regardless of whether their customers are making money. If you have experienced losses due to margin trading, you may be able to recover the funds that you have lost due to stockbroker misconduct.
The attorneys of McCarthy Lebit, Crystal & Liffman are highly skilled at helping investors go after stockbrokers whose malfeasance led to significant investment losses. Our team is highly experienced in all phases of securities arbitration, aggressively advocating to get victims of broker misconduct their money back. To learn more or to schedule a consultation, call us at 866-932-1295, or email us.