Written by D. Daxton White• October 10, 2013• 11:58 am• Blog, Securities Fraud Articles

Understanding How Margin Trading Works

Have you ever considered trading on margin? In recent years the number of investors trading on margin has increased substantially. According to the Financial Industry Regulatory Authority (FINRA), securities purchased on margin averaged more than $320 billion per month in 2012. Unfortunately, many investors may have underestimated the risks associated with margin trading and opened margin accounts without fully understanding how such accounts work.

What is “margin trading?”

Margin trading is basically borrowing money from your broker-dealer to purchase stock. It’s like a loan and the stock you purchase is collateral. When you open a margin account, the “margin” is the amount of money you deposit into the account.

Let’s say for example you want to purchase $1000 worth of stock but only have $500. You decide to open a margin account and borrow $500 from your broker dealer. If the stock goes up and is now worth $1500 you’ve doubled the amount of money you put into the investment. Once you sell the stock, repay the loan with interest, you will have made a substantial profit considering you started out with only $500. Comparatively, if you would have only purchased $500 in stock with cash, you’ll only earn 50% return on your investment and earned far less profits.

With potential for such high returns, it is easy to see why so many investors are attracted to margin. However, if you fully understand the risks and account structure, the appeal to trade on margin begins to dwindle.

Now, let’s consider what happens if the price of the stock falls. For example, if you paid cash for a $1000 in stock and it falls to $500, you’re out 50% of your money. But if you bought the stock on margin, borrowing $500 and putting up $500 in cash, you lose 100% of your money and still have to pay back your broker-dealer plus interest.

Understanding the risks

Trading on margin not only increases your purchasing power and potential profits, but also your risk and downside. When you trade on margin you run the risk of losing more money than you invested. According to FINRA, before you open a margin account, you should fully understand that:

– Your firm can force the sale of securities in your accounts to meet a margin call

– Your firm can sell your securities without contacting you

– You are not entitled to choose which securities or other assets in your accounts are sold

– Your firm can increase its margin requirements at any time and is not required to provide you with advance notice

– You are not entitled to an extension of time on a margin call

How Margin accounts Work

In order to open a margin account your broker dealer is required to obtain your signature and provide you with an agreement explaining the terms and conditions of the account. Before you begin trading on margin, FINRA requires a minimum deposit of $2000 or 100% of the purchase price, though some broker-dealers may require more. Your deposit is known as “margin minimum.” The amount you borrow, called the “initial margin,” cannot exceed 50% of the purchase price of the stock. After you buy stock on margin, there are restrictions on your account called “maintenance margin,” that require you to keep a minimum amount of equity in the account. FINRA requires you to keep a minimum of 25% of the current value of the securities in your account. However, most broker-dealers require maintenance margins between 30% to 40%.

When your margin account falls below the maintenance margin requirements, your broker-dealer will issue a “margin call” and ask you to deposit more cash or stocks into your account. If you do not meet the margin call, your broker-dealer has the right to sell your stock in order to increase your account equity until you reach the required maintenance margin. Although most broker-dealers will attempt to notify you, they are not required to make a margin call and can sell your stocks without consulting you first. In addition, broker-dealers can increase maintenance margin requirements at any time and without prior notice.

You can loose your money fast if you are not familiar with your broker-dealers margin policies. Even if you are notified and given a specific date to meet a margin call, your broker-dealer still has the right to immediately sell your stocks. This often occurs when the market value of your stocks continue to fall. Furthermore, you have no control over which stocks your broker-dealer chooses to sell so there can be collateral damages of a margin call, like tax implications.

Trading on margin is risky business and not appropriate for most investors. It is imperative that you fully understand the risks of trading on margin and monitor your account daily. Broker-dealers manage margin accounts in order to protect their financial interests, not yours. In some cases, when broker-dealers do not adequately explain the risks associated with trading on margin, they may be in violation of securities regulations. If your broker-dealer makes recommendations to trade on margin that significantly increases your risk, for example suggesting you take out a home-equity line of credit to meet a margin call, they may be liable for negligence and responsible for investment losses.

The White Law Group is dedicated exclusively to the representation of investors in claims against their broker-dealers. Our attorneys are experienced in all aspects of securities law, including SEC and FINRA regulations. We understand the risks and obligations brokers have to clients associated with margin trading. If you believe your margin account was mismanaged or that your broker-dealer made unsuitable recommendations, please call the securities attorneys of The White Law Group at (312)238-9650 for a free consultation.

The White Law Group is a national securities fraud, securities arbitration, and investor protection/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida.

For more information on The White Law Group, visit www.WhiteSecuritesLaw.com.