Margin is the term used in the financial industry when a customer borrows money either to purchase investments, or to use those investments as collateral for a loan. In many instances, investing on margin is not suitable, and exposes the investor to risk that is unsuitable for the particular investor. Margin investing adds considerable risk to your portfolio, and you should understand it thoroughly before signing any agreement that permits margin, or permitting margin investing in your portfolio.
Stockbrokers have a duty to investigate the ability of an investor to afford the financial risks inherent in a margin transaction, and to determine whether the investor understands the risks in a margin transaction before recommending a client sign a margin agreement and before entering into such a transaction. If they fail to investigate an investor's ability to incur the risk in a margin account, or if they fail to make certain that the investor understands the risk in a margin transaction, the broker has violated certain duties owed to you, and you may be able to recover any damages incurred as a result of the margin transaction.
When you use a margin account to purchase securities, your brokerage firm is lending you money to purchase these securities. Whether you put up cash equal to some portion of the initial purchase (50%), or if you deposit other stock into the margin account as security for the margin loan, you are borrowing money from your brokerage firm (or its clearing firm) in order to invest. If your account overall or the investment purchased on margin decline in value, you may be required to deposit more funds or securities in your account, or the firm can sell your investments in order to protect their interest. This can cause significant damage to the investor.
Just like at a bank, when you borrow money, you are charged an interest rate. However, the interest rate does not pose the most risk to investing on margin, the volatility of the stock market and/or your portfolio does. If the securities in your margin account decline in value sufficiently, your brokerage firm will require you to immediately deposit more collateral to secure the loan due to the decrease in the value of their collateral--the securities in the account. This is called a margin call. When you receive a margin call, you will either have to deposit additional money into the account, or additional securities. Or, as in most cases, the investor does not have additional securities or money to deposit and the firm will sell enough securities to cover the margin call and meet the required equity maintenance levels. This can be devastating to an account, and can often result in all of the securities in the account being sold, and even have money still owing to the firm.
Trading on margin increases the risk of loss to a customer for two reasons. First, the customer is at risk to lose more than the amount invested if the value of the security depreciates sufficiently. The margined stock could "go to zero" which would require the investor paying off the entire amount of the loan, plus interest, without having any value in the collateral. Second, the interest being charged to the account adds to the investors costs, thereby requiring the investments to appreciate even more to cover the cost of the interest before the customer realizes a net gain. Keep in mind that purchasing securities on margin permits an investor to buy twice the amount of securities for roughly half as much capital; however, the commissions are charged on the total amount of securities purchased. While margin investing can sometimes be suitable for the sophisticated investor, it benefits the broker and the firm regardless of the profile of the investor.
When you get a margin call due to your securities declining in value, if you fail to timely meet the call by depositing sufficient cash or other marginable securities into your account, your brokerage firm is required to sell your securities at the market, even without notice to you. When this happens, you will still owe your brokerage firm the full amount of the amount borrowed, less whatever proceeds were derived from the sale of your securities, usually at relatively low prices in a declining market.
While the use of margin can be an effective use of leverage to an investor who is capable of affording and understanding the risks, it is not typically a prudent tool for the average retail investor. When investors are wrongfully encouraged to use margin, possibly so that the broker can charge commissions on larger transactions, this amounts to a violation of industry rules and stockbroker fraud.
Many investors don't fully understand margin investing, and this may cause them to underestimate the risks of margin trading. It is up to the broker to make certain customers understand the risks before entering into a transaction. If you underestimated the impact margin can have on your accounts, or you do not understand margin, you should investigate whether your broker failed to fully inform you of the risks or that margin was not appropriate for you at any level. Such activity may be the sign that other inappropriate activity has taken place in your accounts.
To learn more about unsuitable or excessive margin, call us at 903-597-2221 or contact us online.