Margin Accounts Explained

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Margin is generally available to investors in their brokerage accounts to purchase securities or for use as a traditional loan (i.e. cash flow, home renovation, wedding, etc.). Margin is not available for use in Individual Retirement Accounts (IRAs) or other qualified accounts. Most brokerage firm websites provide information about various margin lending programs.

The topic of whether to have access to margin generally occurs when your investment account is opened, and in doing so, you would sign margin agreement. Margin may or may not be right for you. The Securities and Exchange Commission (SEC) and Financial Regulatory Authority, Inc. (FINRA) both provide investors with an itemized list of issues, including risks, associated with the use of margin. 

Regulation T of the Federal Reserve Board states that an investor can borrow up to 50% of the purchase price of a security. Some firms may require you to deposit more than 50% of the purchase price.

Can You Use Margin to Purchase Stock?

Let’s say you buy a stock for $100/share and the price of the stock rises to $150/share. If you purchased the stock in a traditional cash account, you would have earned a 50% positive return on your investment. However, if you purchased the stock on margin, you would pay $50 in cash from your account and borrow the other $50 from your brokerage firm. In this example, you would earn a 100% return on the money you invested (your $50/share gain is 100% of your initial $50 investment). PS the firm earns interest on the $50 used on margin.

Keeping with the same example, let’s say instead of appreciating in value, the stock price declines to $50/share. If you purchased the stock in a traditional cash account, you would have a 50% loss, but if you purchased the stock on margin, you would have a 100% loss (your $50 loss is 100% of your initial investment of $50).

The example above is a simple isolated example; however, in portfolio where many investments were purchased on margin, things can get complicated, which is why you need to have a clear understanding of the risks associated with margin, which include, but may not be limited to:

  • You can lose more money than you initially invested;
  • You may have to deposit additional cash or securities to maintain a requisite equity level (see below);
  • Your brokerage firm can exercise its right to sell securities without consulting you to cover a margin debt; and
  • Your brokerage firm can choose which securities to liquidate to cover a margin debt.

Simple fact: Financial institutions that loan you money will do whatever they can to protect themselves, they are not going to be left holding the bag.

We all know that the stock markets move up and down some days are more volatile than others. As markets ebb and flow, the values of an investor’s portfolio, depending on the underlying securities, also fluctuate in value. Those portfolios that have margin are actively monitored by the firm not necessarily for your protection, but rather to protect the firm’s loan to you and because FINRA rules require your brokerage firm to impose a maintenance requirement on your margin account.

The maintenance requirement specifies the minimum amount of equity you must maintain in your margin account at all times. Remember that the firms at a bare minimum must comply with FINRA’s mandated minimum requirements, but they may also increase their own minimums, which many do for their own protection. FINRA requires that an investor maintain at least 25% equity in the account of the total market value of the securities purchased on margin.

Margin Maintenance Requirement Resulting in a Margin Call

Let’s say an investor buys $500,000 worth of five stocks in the energy sector, with $250,000 in cash and $250,000 borrowed from the brokerage firm. The investor, based on the research reports from his broker’s firm, believed that the energy sector is poised to appreciate in the next twelve months. However, three months after the purchase of the five energy stocks, negative news surfaces broadly impacting the energy sector, and the value of the five stocks decreases in value to $300,000 in a period of days. The equity in the investor’s account is now $50,000 ($300,000 – $250,000 = $50,000). If your brokerage firm adheres to FINRA’s rule of 25% of market value of the margined securities, the investor must have $75,000 in his/her account (25 percent of $300,000 + $75,000). In this example, the investor must come up with another $25,000 (difference between the $50,000 equity and margin maintenance requirement) in either cash or securities to satisfy the margin maintenance requirement.

This is a rather extreme example because on the surface the portfolio described above appears unsuitable, i.e. 100% of the liquid assets were invested in the energy sector alone. Putting that issue aside for a moment, the investor in the above example is now left scrambling to come up with another $25,000. We have seen the above scenario from the perspective of defending the firm and the aggrieved investor:

Typically, the firm will take whatever measures it can to mitigate any losses associated with money lent, while at the same time, the investor typically seeks more flexibility to deal with the margin maintenance call. 

The investor may wholeheartedly believe that whatever negative news impacted the energy sector will be short lived and there are credible reasons to believe that the negative news will reverse course, thus, the margin maintenance requirement will be alleviated when the value of energy securities rebounds back to the upside. However, the firm must comply with Regulation T. If the firm’s margin maintenance policy is 40%, then some firms may work with the client to provide some flexibility, so long as the account does not hit the Reg T (25%) threshold. Some of the firm’s decision making may also depend on what energy sector investments were made, i.e. Chevron, a large multinational corporation making up a part of the Dow Jones Industrial average, or Linn Energy, a once heavily-leverage company in its own right teetering on verge of bankruptcy in 2015 (along with many other companies in that sector during that period of time.)

If you are an investor who has been adversely impacted by the use of margin and the handling of your investment portfolio please call the Investment Loss Recovery Group at 1-800-856-3352 for a no-cost consultation and portfolio review. We handle cases nationwide. No Recovery, no Fee. We also pay lawyer-to-lawyer Florida Bar approved referral fees.

 

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