John attended the Kentucky Derby, held at Churchill Downs in Louisville, KY. He looked at the horse Always Dreaming in the paddock area and was sure the horse could win the race. But, he was short of cash to make a bet. A friend offered to loan him $50 and says he can pay her back later. Tempting. If the horse wins, John wins and pays the loan with money to spare. But, what if the horse loses? John would be down his original bet and still owe his friend $50.00. Borrowing money at the track is high stakes gambling—you could win more—but your risk is also higher.
Investing on margin isn’t like betting on a horse race, however there are some parallels. Margin is a high-risk investment strategy that can bring about great profit or great losses. Understanding what it is can help you understand the risk.
What is Margin Trading?
Buying on margin is borrowing money from a broker to purchase stock—think of it as a loan to you to buy more stock than you could afford otherwise. The following are the terms used in margin trading:
- Margin account—it is a separate account from your cash account; your broker must have your signature to set up the account,
- Minimum margin—The Federal Reserve Board (FRB) requires a minimum loan of $2000 to set up a margin account; some brokerage houses require more,
- Initial margin—the amount, up to 50% of the cost of the stock, which you can initially borrow to make the purchase,
- Maintenance Margin—the amount you need to maintain after a trade; it is set at 25% by FRB,
- Margin Call—if your loan account balance falls below 25%, the broker can force you to deposit more funds or sell stock to pay down your loan. Under most agreements, the broker can sell the stock without waiting for your response and you have no control over which of your stocks they can sell.
You can keep the loan as long as you want but when you sell the stock in the margin account, the proceeds go to the broker to pay off the loan. You have to pay interest on your loan debt at time of sale or you can make payments on the interest.
Therefore, buying on margin is used for short-term investments. The longer you hold on to the investment, the more you need to see in a return to break even. The FRB regulates which stocks can be bought on margin. Generally, brokers won’t allow customers to buy penny stocks, over the counter Bulletin Board Securities or initial public offerings on margin.
What are the advantages of Margin?
With margin funds you can purchase more stock on the belief it will increase in value and you make more money. A 50% initial margin allows you to buy twice as much stock as you could with cash alone. Whether you can consistently pick winning stocks is subject to debate, however, if you pick the right investments, margin can greatly increase your profits.
Clearly, margin accounts are risky. When you buy on margin you are investing more money than you have, therefore you can lose more money than you invested. If the stock dips 50% you will lose more than 100% with interest and fees on top of that. With a cash account, you can hang on in hopes that the stock will recover, however, the interest in the margin account is increasing, adding to your loss. And, remember, your broker can sell off your margin account if the stock price dives. This means your losses are set so you can’t participate in any future re-bound.
FINA Rule 4210 (Margin Requirements) describes the margin requirements that determine the amount of collateral customers are expected to maintain in their margin accounts, including both strategy-based accounts, and portfolio margin accounts. The rule explains margin requirements for equity and fixed income securities, along with options, warrants and security futures.
If you think your broker was too aggressive in recommending margin investing to you and you lost a significant percentage of your portfolio you may have a claim.
If you have questions about margin accounts, please contact me at: 313-962-7777 for a case evaluation.