Margin is used in investment accounts by stock brokers and investors to maximize an investors purchasing power. When a stock broker uses margin in connection with a customer's investment account there are major risks that need to be disclosed to the investor. The risks in connection with margin trading in investment account include the higher fees and costs for using margin, the potential for massive losses in excess of what the client has invested, and the ability of the firm to control the sale of the stock or security if margin call is created. Before getting into fraud and risks in connection with Margin trading its essential to examine the fundamentals of margin trading.How Margin Works
People borrow money all the time. To purchase cars and homes, pay for college for their kids, buy furniture and clothing. But do you know that you can also borrow money to purchase securities in your brokerage account?
"Margin" is the term the securities industry uses to describe instances in which a brokerage firm extends credit to a customer to purchase securities. Those securities, held in the customer's account, then become the collateral for the margin loan.
Sounds simple, doesn't it?
In order for a customer to borrow funds from a firm the customer must open a margin account (as opposed to a "cash" account in which the securities purchased must be fully paid for by settlement date). The customer must sign a margin account agreement before the account can be opened (the margin account agreement may be a separate document or contained within the body of a general account agreement). The margin account agreement contains various clauses particular to margin accounts, which will be discussed later.
Once the margin account is opened, the customer may purchase securities on margin. However, before the first purchase, the customer must deposit sufficient funds in the account to meet the minimum margin requirement. FINRA sets that at $2,000; firms can and do set a higher minimum margin requirement.
Furthermore, when purchasing on margin, the client is required to deposit initial margin into the account. Different securities have different initial margin requirements. Some securities are not marginable at all. In the case of common stock, there is a 50% initial margin requirement (again, the firm can set a higher requirement). Therefore, if a customer desires to purchase $6,000 of a common stock, she must deposit at least $3,000 into the account; the firm then loans the client $3,000 to complete the trade. The $6,000 worth of stock then becomes the collateral for the loan.Advantages of Margin Trading
As can be seen from the example in the preceding paragraph, the immediate advantage of trading on margin is that the customer can purchase a larger quantity of a security than if she solely used her available cash. This can enable a customer to take advantage of a perceived trading opportunity. The customer can also use margin to diversify her portfolio by increasing the size and variety of the account holdings.
Lastly, if the price of the stock moves upward, the customer's profit on the position will be greater since, through the use of margin, she was able to acquire a larger number of shares.Disadvantages of Margin Trading
While margin trading affords an investor the opportunity for greater profits, the converse is true: in the case of a market decline, the losses incurred by the investor can be greater in a margin account than in a cash account.
If the value of securities in a margin account declines the account holder may be forced to deposit additional cash or securities into the account or sell some or all of his positions to raise cash. Remember the initial margin requirement discussed above? In that example, if there was a $6,000 purchase with a $3,000 loan, what happens if the $6,000 of stock drops in value to $5,000? Now the customer is only permitted to have a $2,500 loan versus the $5,000 account equity. If the client can't or won't deposit additional funds or securities, the firm has the authority under the margin agreement to sell positions in the account to meet the margin call.
This can result in the sale of securities at a loss. This could mean the imposition of capital gains tax liability if the sale price was greater than the purchase price. It could result in the sales of securities the client intended to hold long term. And under the margin agreement, the firm can sell positions to meet the margin call no matter what the impact may be on the customer.
Lastly, the firm charges interest on the margin loan. Those margin interest charges, reflected monthly on the account statement, are not cheap and will accumulate as long as the margin positions are held.Is Margin Trading Right for You
As discussed above, while there are certainly advantages to margin trading, there are also several severe and identifiable risks. If you are an active trader, the margin interest you will incur will increase your transaction costs, thereby lowering any profits you may receive. Positions in your account, which you may have accumulated over time and want to hold on to, are the subject of margin calls and can be liquidated without your knowledge (you gave the firm authority to do so in the margin agreement). If you don't want those positions liquidated, be prepared to deposit additional cash or securities in the account to meet any margin calls.
Most reputable brokers would tell their clients not to be heavily leveraged in the market to avoid the repercussions of a plummeting market. They would also advise their clients to use margin, if at all, for short term trading strategies to limit the interest charges.
Lastly, margin trading may only be suitable for experienced traders and/or high net worth clients.
If you have questions on the use of margin, or any questions on the handling of your account, CONTACT the experienced securities attorneys at Lubiner, Schmidt & Palumbo for a free consultation.