In today’s fast-moving markets, it can be tempting to try new strategies to increase returns. Many people open a margin account with hopes of turbocharging their results. While some may succeed, many more end up learning a hard lesson about the hidden dangers of adding leverage to your portfolio. Our attorneys have experience representing investors in disputes with their broker-dealers concerning margin balances and autoliqudations. If you would like to discuss your case, please call us at 212-203-9300 for a free and confidential consultation.
Margin trading means borrowing funds from your broker to invest. With interest rates at generational lows, borrowing at rock-bottom rates to invest seems inherently reasonable. Many people appear to agree since margin balances hit all-time highs in 2021.
If used very carefully, margin trading can enhance your investing or trading results.
However, margin trading also gives you leverage, which means any results you achieve will be amplified:
This can create quick and painful losses. Even if the price changes don’t result in big losses, investing on margin can create significant stress in the meantime.
There’s no shortage of dramatic stories out there about what can happen with margin. Earlier this year, a billionaire trader lost almost his entire fortune in two days through a series of margin calls resulting from trades gone wrong. Robinhood has also been in the news with a $70 million fine for misleading customers about margin, resulting in many new investors experiencing fast losses.
The bottom line? People regularly get burned, frequently quite severely, by using margin.
One thing is clear….trading or investing with margin is not to be taken lightly. But is it safe at all? Let’s take a step back and review the facts.
Most brokerage accounts are cash accounts. That means that to buy 100 shares of stock, for example, you must transfer enough cash to cover the entire purchase.
However, if you apply for a margin account, you can now buy stocks or other securities “on margin.” That means you only have to pay part of it in cash. You borrow the rest from the broker. This allows you to buy significantly more than your cash level permits. You then pay the broker interest monthly for the use of the funds (the margin loan).
If your stocks go up in value, you make a higher return than you would have if you were limited to cash purchases. This is the positive side of using margin.
Here’s the problem. If your investments drop in value, two things happen:
There are two types of margin requirements you will be responsible for meeting.
The first type of margin requirement is the Regulation T margin. Regulation T is a Federal Reserve Board Requirement that controls the initial purchase in a brokerage account. Regulation T limits the initial amount you can borrow to 50% of the purchase price. You must fund the remainder with cash. Please note that some brokers may have stricter initial requirements, as well.
Once your account is established, you must maintain certain cash levels. That level is the maintenance margin, the second type of margin requirement you must meet. The maintenance margin, according to federal regulations, is 25%. However, in practice, many firms set the requirement at 30% or more.
Additionally, more volatile stocks may require higher maintenance margins. Highly volatile or speculative securities may not be eligible for margin at all.
The broker-dealer tracks your margin requirements and equity daily. Your account equity is the total value of your investments minus the amount of the loan. All those numbers usually appear on your account dashboard, so it is easy to monitor them.
You will get a margin call if your account’s equity drops below that margin maintenance requirement.
A margin call is a demand to increase the equity in your account when your account value drops below the maintenance margin. While the broker-dealer is not technically required to notify you of a call, usually, you will receive a notice by email.
To meet the margin call, you have these choices:
There’s an old market adage that you should “never meet a margin call” with additional cash. While it is all a choice, that can be good advice. Because while people dread margin calls, it can act as a safety mechanism. Why? Some people automatically deposit additional cash but then stand by as their investments drop further. By depositing money, you put extra cash at risk of loss. So often, selling might be the more conservative choice.
There is no set rule on this, but most firms allow you two to five days. However, the broker as the lender does have the ability to require the call to be addressed immediately during exceptionally volatile markets. In that case, you may need to add funds or sell investments within 24 hours. In extraordinary circumstances, the broker may even take action sooner.
As you can see, if you choose to invest on margin, you need to pay attention to your account. If you choose to ignore a margin call, the brokerage firm can liquidate or force a sale of all or part of your securities. In that case, they decide what and when to sell. That’s why it is usually in your best interest to act first, so you can decide the course of action you’d like to take.
Most account agreements allow brokers to adjust margin requirements at any time. Many large broker-dealers changed margin requirements for individual stocks near the US election of 2020 when volatility was high. Additionally, most margin agreements allow a brokerage firm to ask you to deposit additional capital in your account or sell your investments if they have reason to believe their own funds are at risk. Further, they have the right to sue you if you don’t remedy a margin call or carry a negative balance in your account.
Unfortunately, due to accrued interest on the loan and other factors, you can actually lose more than you started with. Unlucky investors have been left owing their brokerage firm additional money.
You can probably see that while margin accounts can be used carefully, these accounts can be downright dangerous if given to those who are not well-informed. Even experienced investors can get caught in bad situations during black swan events and other periods of extreme market volatility.
These dangers don’t exist with cash accounts. If prices drop while you’re in a cash account, you can simply wait for your holdings to rebound. There’s no time pressure and no fear of getting sold out.
So you must approach margin with care. If you do want to use margin, here are a few tips to help keep things on track:
One bright spot: in today’s volatile investment climate, some of the risks are being reduced for investors. Many brokerages will not loan on risky securities at all or have dramatically increased the margins for stocks that tend to be volatile.
If you are going to trade on margin, you should commit to getting educated. Read all the documentation associated with the margin account. Monitor the account regularly. And most importantly, if you do get a margin call, take action fast so that you can maintain control of your account.
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