Investing on margin can be incredibly risky, and appropriate only for the most sophisticated investors who can afford it. And yet, as investment fraud attorneys, we are often surprised by the number of “ordinary” investors who contact our offices because they have been sold on the idea of investing on margin by their financial advisor.
Unfortunately, many of these investors learn the hard way. Rather than making money, investing on margin is a great way to wipe out your entire portfolio.
What is “buying on margin”?
Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage firm. This can sound like an enticing proposition because it allows you to buy more stock than you would normally be able to with the cash in your account. It also comes with significant costs, including margin interests, which is the interest on the loan you are taking from the brokerage firm.
Initial Margin Requirement
Also, margin rules allow an investor to initially borrow as much as 50% of the purchase price of a stock on margin. This is known as the “initial margin requirement.”
Maintenance Margin Requirement
There is also a separate maintenance margin requirement, which is the minimum account balance you must maintain. Under industry rules, the maintenance margin requirement is 25% of the current market value of the securities in the account.
If your account falls beneath this 25% threshold, then your broker will force you to either deposit more money in the account or sell stock to pay down the loan. This is called a “margin call,” and the effect is that you are losing more money than you initially deposited in the first place. When margin calls come, many investors are surprised to learn that their brokerage firm can force the sale of securities in their account, and even sell securities in your account without even contacting you.
As a matter of good customer relations, most firms will attempt to notify their customers of margin calls, but they aren’t required to do so. At the end of the day, while customers can use margin to increase their investments and leverage their purchasing power, customers who trade on margin can also magnify their losses when the stock price goes the other way. This is particularly so in volatile markets like we experienced in late 2008 and early 2009.
Unless you have plenty of money elsewhere and can afford to take the risk, you are likely much better off staying away from margin and investing with just the cash you have on hand.