Margin: Should I Use It?
Margin:
Borrowing Money To Pay for Stocks
"Margin" is borrowing money from your broker to buy a
stock and using your investment as collateral. Investors
generally use margin to increase their purchasing power so
that they can own more stock without fully paying for it.
But margin exposes investors to the potential for higher
losses. Here's what you need to know about margin.
Understand How Margin Works
Let's say you buy a stock for $50 and the price of the
stock rises to $75. If you bought the stock in a cash
account and paid for it in full, you'll earn a 50 percent
return on your investment. But if you bought the stock on
margin – paying $25 in cash and borrowing $25 from your
broker – you'll earn a 100 percent return on the money you
invested. Of course, you'll still owe your firm $25 plus
interest.
The downside to using margin is that if the stock price
decreases, substantial losses can mount quickly. For
example, let's say the stock you bought for $50 falls to
$25. If you fully paid for the stock, you'll lose 50 percent
of your money. But if you bought on margin, you'll lose 100
percent, and you still must come up with the interest you
owe on the loan.
In volatile markets, investors who put up an initial
margin payment for a stock may, from time to time, be
required to provide additional cash if the price of the
stock falls. Some investors have been shocked to find out
that the brokerage firm has the right to sell their
securities that were bought on margin – without any
notification and potentially at a substantial loss to the
investor. If your broker sells your stock after the price
has plummeted, then you've lost out on the chance to recoup
your losses if the market bounces back.
Recognize the Risks
Margin accounts can be very risky and they are not
suitable for everyone. Before opening a margin account, you
should fully understand that:
- You can lose more money than you have invested;
- You may have to deposit additional cash or securities
in your account on short notice to cover market losses;
- You may be forced to sell some or all of your
securities when falling stock prices reduce the value of
your securities; and
- Your brokerage firm may sell some or all of your
securities without consulting you to pay off the loan it
made to you.
You can protect yourself by knowing how a margin account
works and what happens if the price of the stock purchased
on margin declines. Know that your firm charges you interest
for borrowing money and how that will affect the total
return on your investments. Be sure to ask your broker
whether it makes sense for you to trade on margin in light
of your financial resources, investment objectives, and
tolerance for risk.
Read Your Margin Agreement
To open a margin account, your broker is required to
obtain your signature. The agreement may be part of your
account opening agreement or may be a separate agreement.
The margin agreement states that you must abide by the rules
of the Federal Reserve Board, the New York Stock Exchange,
the National Association of Securities Dealers, Inc., and
the firm where you have set up your margin account. Be sure
to carefully review the agreement before you sign it.
As with most loans, the margin agreement explains the
terms and conditions of the margin account. The agreement
describes how the interest on the loan is calculated, how
you are responsible for repaying the loan, and how the
securities you purchase serve as collateral for the loan.
Carefully review the agreement to determine what notice, if
any, your firm must give you before selling your securities
to collect the money you have borrowed.
Know the Margin Rules
The Federal Reserve Board and many self-regulatory
organizations (SROs), such as the NYSE and NASD, have rules
that govern margin trading. Brokerage firms can establish
their own requirements as long as they are at least as
restrictive as the Federal Reserve Board and SRO rules. Here
are some of the key rules you should know:
Before You Trade – Minimum Margin
Before trading on margin, the NYSE and NASD, for example,
require you to deposit with your brokerage firm a minimum of
$2,000 or 100 percent of the purchase price, whichever is
less. This is known as the "minimum margin." Some firms may
require you to deposit more than $2,000.
Amount You Can Borrow – Initial Margin
According to Regulation T of the Federal Reserve Board,
you may borrow up to 50 percent of the purchase price of
securities that can be purchased on margin. This is known as
the "initial margin." Some firms require you to deposit more
than 50 percent of the purchase price. Also be aware that
not all securities can be purchased on margin.
Amount You Need After You Trade – Maintenance Margin
After you buy stock on margin, the NYSE and NASD require
you to keep a minimum amount of equity in your margin
account. The equity in your account is the value of your
securities less how much you owe to your brokerage firm. The
rules require you to have at least 25 percent of the total
market value of the securities in your margin account at all
times. The 25 percent is called the "maintenance
requirement." In fact, many brokerage firms have higher
maintenance requirements, typically between 30 to 40
percent, and sometimes higher depending on the type of stock
purchased.
Here's an example of how maintenance requirements work.
Let's say you purchase $16,000 worth of securities by
borrowing $8,000 from your firm and paying $8,000 in cash or
securities. If the market value of the securities drops to
$12,000, the equity in your account will fall to $4,000
($12,000 - $8,000 = $4,000). If your firm has a 25 percent
maintenance requirement, you must have $3,000 in equity in
your account (25 percent of $12,000 = $3,000). In this case,
you do have enough equity because the $4,000 in equity in
your account is greater than the $3,000 maintenance
requirement.
But if your firm has a maintenance requirement of 40
percent, you would not have enough equity. The firm would
require you to have $4,800 in equity (40 percent of $12,000
= $4,800). Your $4,000 in equity is less than the firm's
$4,800 maintenance requirement. As a result, the firm may
issue you a "margin call," since the equity in your account
has fallen $800 below the firm's maintenance requirement.
Understand Margin Calls – You Can Lose Your Money Fast
and With No Notice
If your account falls below the firm's maintenance
requirement, your firm generally will make a margin call to
ask you to deposit more cash or securities into your
account. If you are unable to meet the margin call, your
firm will sell your securities to increase the equity in
your account up to or above the firm's maintenance
requirement.
Always remember that your broker may not be required
to make a margin call or otherwise tell you that your
account has fallen below the firm's maintenance requirement.
Your broker may be able to sell your securities at any time
without consulting you first. Under most margin
agreements, even if your firm offers to give you time to
increase the equity in your account, it can sell your
securities without waiting for you to meet the margin call.
Ask Yourself These Key Questions
- Do you know that margin accounts involve a great deal
more risk than cash accounts where you fully pay for the
securities you purchase? Are you aware you may lose more
than the amount of money you initially invested when
buying on margin? Can you afford to lose more money than
the amount you have invested?
- Did you take the time to read the margin agreement?
Did you ask your broker questions about how a margin
account works and whether it's appropriate for you to
trade on margin? Did your broker explain the terms and
conditions of the margin agreement?
- Are you aware of the costs you will be charged on
money you borrow from your firm and how these costs affect
your overall return?
- Are you aware that your brokerage firm can sell your
securities without notice to you when you don't have
sufficient equity in your margin account?
Learn More About Margin Trading
For more information,
visit the website of NASD where you can read from a
collection of articles and other resources on margin
trading.
http://www.sec.gov/investor/pubs/margin.htm
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