When may margin be appropriate?
September 11, 2003
Investor purchases of securities "on margin" have grown dramatically in recent months. As NASD recently reported, the amount of debt taken on to buy securities reached $174 billion in July, an increase of over 25% since the beginning of the year. Some commentators see this growth as a sign that the speculative trading of the late '90s may be returning.
NASD is issuing this Alert because we are concerned that many investors may underestimate the risks of trading on margin and misunderstand the operation and reason for margin calls. Investors who cannot satisfy margin calls can have large portions of their accounts liquidated under unfavorable market conditions. These liquidations can create substantial losses for investors.
Before you decide to open a margin account, make sure you understand the following risks:
- 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
- You can lose more money than you deposit in a margin account
This Alert will explain these risks and provide you with some basic facts about purchasing securities on margin.
How Margin Accounts Work
With a margin account, you can borrow money from your brokerage firm to purchase securities. The portion of the purchase price that you must deposit is called margin and is your initial equity or value in the account. The loan from the firm is secured by the securities you purchase. If the securities you're using as collateral go down in price, your firm can issue a margin call, which is a demand that you repay all or part of the loan with cash, a deposit of securities from outside your account, or by selling some of the securities in your account.
|Caution! Buying on margin amounts to getting a loan from your firm. When you buy on margin, you must repay both the amount you borrowed and interest, even if you lose money on your investment. Some brokerage firms automatically open margin accounts for investors. Make sure that you understand what type of account you are opening. If you don't want to trade on margin, choose a cash account for your transactions.|
Buying on margin carries a cost. This cost is the interest you will pay on the amount you borrow until it is repaid. Margin interest rates generally vary based on the current "broker call rate" or "call money rate" and the amount you borrow. Rates also vary from firm to firm. You can find the current "call money" rate in The Wall Street Journal listed under "Money Rates." Most brokerage firms publish their current margin interest rates on their Web sites.
|Margin Loans: Who's Profiting?|
Margin loans can be highly profitable for your brokerage firm. They may also be highly profitable for your broker. Your broker may receive fees based on the amount of your margin loans. This may take the form of a percentage of the interest you pay on an ongoing basis.
The Federal Reserve Board, NASD, and securities exchanges, including the New York Stock Exchange (NYSE), regulate margin trading. Most brokerage firms also establish their own more stringent margin requirements. This Alert focuses on the requirements for purchases of marginable equity securities, which include stocks traded in the U.S. Different requirements apply to short sales, securities futures, other types of securities, and certain foreign securities.
Before purchasing a security on margin, NASD Rule 2520 and NYSE Rule 431 require that you deposit $2000 or 100% of the purchase price--whichever is less--in your account. This is called "minimum margin." If you will be day trading, you are required to deposit $25,000. To learn more about day-trading margin requirements, please read Day Trading Margin Requirements: Know the Rules.
In general, under Federal Reserve Board Regulation T, you can borrow up to 50% of the total purchase price of a stock for new, or initial, purchases. This is called "initial margin." Assuming you do not already have cash or other securities in your account to cover your share of the purchase price, you will receive a margin call (or "Fed call") from your firm that requires you to deposit the other 50% of the purchase price.
After you purchase a stock on margin, NASD Rule 2520 and NYSE Rule 431 supplement the requirements of Regulation T by placing "maintenance margin requirements" on your accounts. Under these rules, as a general matter, your equity in the account must not fall below 25% of the current market value of the securities in the account. If it does, you will receive a maintenance margin call that requires you to deposit more funds or securities in order to maintain the equity at the 25% level. The failure to do so may cause your firm to force the sale of--or liquidate--the securities in your account to bring the account's equity back up to the required level.
Your firm has the right to set its own margin requirements--often called "house requirements"--as long as they are higher than the margin requirements under Regulation T or the rules of NASD and the exchanges. Some firms raise their maintenance margin requirements for certain volatile stocks or a concentrated or large position in a single stock to help ensure that there are sufficient funds in their customer accounts to cover the large swings in the price of these securities. In some cases, a firm may not even permit you to purchase or own certain securities on margin. These changes in firm policy often take effect immediately and may result in the issuance of a maintenance margin call (or "house call"). Again, if you fail to satisfy the call, your firm may liquidate a portion of your account.
|Margin Transaction -- Example|
For example, if you buy $100,000 of securities on Day 1, Regulation T would require you to deposit initial margin of 50% or $50,000 in payment for the securities. As a result, your equity in the margin account is $50,000, and you have received a margin loan of $50,000 from the firm. Assume that on Day 2 the market value of the securities falls to $60,000. Under this scenario, your margin loan from the firm would remain at $50,000, and your account equity would fall to $10,000 ($60,000 market value minus $50,000 loan amount). However, the minimum maintenance margin requirement for the account is 25%, meaning that your equity must not fall below $15,000 ($60,000 market value multiplied by 25%). Since the required equity is $15,000, you would receive a maintenance margin call for $5,000 ($15,000 less existing equity of $10,000). Because of the way the margin rules operate, if the firm liquidated securities in the account to meet the maintenance margin call, it would need to liquidate $20,000 of securities.
Margin Trading Risks
There are a number of risks that you need to consider in deciding to trade securities on margin. These include:
- Your firm can force the sale of securities in your accounts to meet a margin call. If the equity in your account falls below the maintenance margin requirements under the law--or the firm's higher "house" requirements--your firm can sell the securities in your accounts to cover the margin deficiency. You will also be responsible for any short fall in the accounts after such a sale.
- Your firm can sell your securities without contacting you. Some investors mistakenly believe that a firm must contact them first for a margin call to be valid. This is not the case. Most firms will attempt to notify their customers of margin calls, but they are not required to do so. Even if you're contacted and provided with a specific date to meet a margin call, your firm may decide to sell some or all of your securities before that date without any further notice to you. For example, your firm may take this action because the market value of your securities has continued to decline in value.
- You are not entitled to choose which securities or other assets in your accounts are sold. There is no provision in the margin rules that gives you the right to control liquidation decisions. Your firm may decide to sell any of the securities that are collateral for your margin loan to protect its interests.
- Your firm can increase its "house" maintenance requirements at any time and is not required to provide you with advance notice. These changes in firm policy often take effect immediately and may cause a house call. If you don't satisfy this call, your firm may liquidate or sell securities in your accounts.
- You are not entitled to an extension of time on a margin call. While an extension of time to meet a margin call may be available to you under certain conditions, you do not have a right to the extension.
- You can lose more money than you deposit in a margin account. A decline in the value of the securities you purchased on margin may require you to provide additional money to your firm to avoid the forced sale of those securities or other securities in your accounts.
Do Your Margin Homework!
- Make sure you fully understand how a margin account works. If you don't, limit your investments to a cash account. Cash accounts are not subject to margin calls. It is important to take time to learn about the risks involved in trading securities on margin. Consult with your broker about any concerns you may have with your margin account.
- Know the margin rules. We've discussed some of the margin requirements in this Alert. To learn more, you can find NASD Rule 2520 and Regulation T in the NASD Manual.
- Know your firm's margin policies. Read your firm's margin agreement and margin disclosure statement. Speak with your broker or check your firm's Web site for any changes in margin policies. Firms can make changes at their discretion, and are more likely to do so in volatile markets.
- If you use a margin account, you may not want to use all your available money to trade securities in your margin account. For example, you may want to keep some money in a checking or savings account so that you can promptly meet a margin call.
- Manage your margin account. Margin accounts require work. Monitor the price of the securities in your margin account on a daily basis. If you see that the securities in your account are declining in value, you may want to consider depositing additional cash or securities to attempt to avoid a margin call. If you receive a margin call, act promptly to satisfy the margin call. By depositing cash or selling securities that you choose, you may be able to avoid your firm liquidating or selling securities it chooses.
This information on Margin is © 2005 NASD. All rights reserved. To find out more about Margin at NASD, click here.