Margin Calls Explained: Why Margin Accounts Unsuitable for Most Investors
“Margin investing” is borrowing from a brokerage to buy more securities. Investing on margin increases the potential for big returns if the price of the selected securities increases. These types of loans capitalize on an investor’s fear of missing out on a significant return. Margin investing also increases the risk, as you can lose much more than you initially invested.
A margin account is a brokerage account that allows the broker to lend an investor cash to purchase stocks or other financial products. Buying stocks with borrowed money is also called purchasing on “leverage.” Leverage always magnifies the risk for losses.
The consequences of margin investing can be financially devastating. This is for two reasons:
- Margin loans charge interest. In exchange for the loan, the brokerage firm charges interest on the margin funds for as long as the loan is outstanding. This interest reduces the investor’s profit.
- The investor’s cash and eligible securities serve as collateral for the loan. Investors can easily lose their entire investment, plus the collateral if the investments do not perform well.
Your broker should make these risks clear when you open a margin account and explain what happens during a margin call. If these risks were not explained, you may be entitled to recover losses through FINRA arbitration.
In addition to interest, margin loans may also come with broker fees. Some brokerage firms do not charge broker fees because they make enough money from the margin loan interest rate. Make sure you check with your broker and understand how they calculate their margin loans.
Margin loans of less than $25,000 would typically have an interest rate of around 8%.
How Do Margin Accounts Work?
Brokerage firms have initial margin requirements, or minimum margin requirements, requiring the investor to put a minimum amount in the account before borrowing from the broker. In general, an investor is required to deposit a minimum of $2,000 or 100% of the purchase price of the margin securities, whichever is less. For example, if an investor wants to buy $10,000 in shares of a certain stock, they must put in $5,000 of their own money.
Federal agencies set account minimums and limit how much investors can borrow at one time. FINRA requires that margin accounts must not fall below 25% of the market value of their securities. This is called a “maintenance margin.” If you put $10,000 in your margin account and your account has a maintenance margin of 25%, your maintenance margin would be $2,500.
Certain brokerage firms have higher maintenance margins – 30% or more is common.
Margin Calls Explained
If a margin account drops below maintenance level, the brokerage firm will make a margin call to the investor. A margin call refers specifically to a broker’s demand that an investor deposit additional money or securities into the account to bring it up to the minimum value, known as the maintenance margin. A margin call is triggered when the investor’s equity falls below the maintenance margin. If the investor cannot afford to pay the required amount to bring the value of their portfolio up to the account maintenance margin, the broker may be forced to liquidate securities in the account. This compounds the already significant risk for losses.
Did Your Brokerage Firm Approve You for a Risky Margin Loan?
Your brokerage firm must approve your margin loan, and they should take your financial situation into consideration before they approve you. FINRA Rule 2111 requires that brokers only recommend investment strategies that suit your financial goals. If you believe you were approved for an unsuitable margin account, contact a securities lawyer.
Margin Trading Example
Brokers can sell the idea of margin trading with a description of potentially huge returns. If you have $10,000 to invest and open a margin account with $10,000, you can purchase $20,000 worth of a certain security.
- If that security’s price goes up by 20%, you get to add that extra $4,000 to your total equity – minus any broker fees and the interest on your margin loan.
- If you had only purchased $10,000 of that same share, you would only have earned $2,000.
- By doubling your investment, you also double your interest.
Is Margin Trading a Good Idea?
Because of the potential for losses, margin trading is not a prudent choice for most investors.
Let’s say the investment does not perform as well as your broker hoped.
- If the price of your securities decreases by 50%, the total value of your account decreases by $10,000.
- At this point, you will have lost your initial investment, and you owe any commissions and interest on the loan your broker charges.
The Dangers of Investing on Margin
Aside from the danger to the individual investor, economists say that margin borrowing can drive bubbles in the economy. When lots of investors buy shares using margin, they increase the chance the stock will experience volatility – i.e., sharp price changes. According to The Wall Street Journal, increased margin borrowing preceded economic crashes in 2000 and 2008. This is another reason not to necessarily follow the crowd. When the stock market does well, investors fear missing out on big upswings. But the reality is that it is far more likely you will lose money.
Unscrupulous brokers might sell you on a certain security because of the commissions. Always be wary when a broker makes it sound like an investment is a sure thing. If a broker guaranteed you a return, you may be entitled to recover your losses. Contact Kurta Law for a free case evaluation with a securities attorney: 877-600-0098 or email@example.com.