Understanding Margin Trading Risks and Requirements
The Financial Industry Regulatory Authority (FINRA) recently issued an investor alert highlighting risks associated with margin trading. It is crucial for investors to be aware of how margin accounts operate and the potential consequences of margin calls during unfavorable market conditions.
Risks of Margin Trading
Trading on margin carries significant risks, including:
- Forced Liquidation: Your brokerage firm can sell securities in your account to meet a margin call, even without notifying you.
- No Choice of Assets Sold: You do not have the right to decide which securities or assets are liquidated.
- Increased Margin Requirements: Firms can raise margin requirements at any time without prior notice.
- No Extensions: Extensions on margin calls are not guaranteed.
- Losses Beyond Deposits: You can lose more money than you originally deposited.
How Margin Accounts Work
A margin account allows you to borrow money from your brokerage to purchase securities. The portion of the purchase price you deposit is your margin or equity. The securities you purchase act as collateral for the loan.
If the value of your collateral decreases, the firm may issue a margin call, requiring you to repay part or all of the loan through cash, securities, or the sale of assets in your account. Borrowed funds must be repaid with interest, regardless of whether your investment gains or loses value.
Some firms automatically open margin accounts for investors. To avoid trading on margin, ensure you opt for a cash account when opening a brokerage account.
Margin Costs
The primary cost of trading on margin is the interest charged on borrowed funds, which accrues until the loan is repaid. These rates vary by firm and are often tied to the “broker call rate.” Firms typically publish their margin interest rates online.
Margin loans can be highly profitable for brokerage firms, which may earn fees based on the size of the loan.
Margin Requirements
Margin trading is regulated by the Federal Reserve Board, FINRA, and exchanges like the NYSE. Brokerage firms may set stricter requirements, known as “house requirements.”
- Minimum Margin: Under FINRA Rule 4210, investors must deposit $2,000 or 100% of the purchase price (whichever is less) before buying on margin. Day traders must maintain a $25,000 account balance.
- Initial Margin: Investors must cover at least 50% of the purchase price of securities. If you lack sufficient funds, you’ll receive a margin call to cover the remaining amount.
- Maintenance Margin: FINRA requires account equity to remain above 25% of the securities’ market value. If it falls below this threshold, a maintenance margin call is issued, and failing to meet it may result in forced liquidation of assets.
House Requirements
Brokerage firms may impose stricter requirements, often for volatile stocks or concentrated positions. These policies may change without notice and can result in immediate margin calls or restrictions on purchasing specific securities on margin.
Key Risks to Consider
When trading on margin, keep these risks in mind:
- Forced Sales: Firms can sell your securities to cover margin deficiencies without notifying you.
- No Contact Requirement: Brokers are not obligated to notify you before executing a margin call.
- Loss of Control: You cannot choose which assets are sold during liquidation.
- Immediate Policy Changes: Firms can alter margin requirements without warning.
- Unlimited Loss Potential: Losses can exceed your initial deposit.
- Short-Sale Costs: Interest on open short positions continues, even if a stock is delisted or halted.
Margin trading can amplify both gains and losses. Understanding these risks and regulations is essential for making informed investment decisions.
The foregoing information, which is all publicly available on FINRA’s website, is being provided by The White Law Group.
The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm dedicated to the representation of investors in FINRA arbitration claims against brokerage firms throughout the United States. We have offices in Chicago, Illinois and Seattle, Washington and we represent investors in all 50 states.
