Margin Accounts and Volatile Markets
When most people begin to invest in securities with a brokerage firm, they do so by opening what is known as a "Cash Account." This means that when a transaction is made, the purchase is paid for in full or certificates for shares sold are delivered to the broker.
A more sophisticated investment strategy involves opening a "Margin Account." In a margin account, an investor pays only a percentage of the cost at the time of purchase. The remainder is carried as a debit balance to be paid by the customer when the security is sold or the customer decides to pay off the debit balance.
Before you decide to open a margin account, you should be aware of the terms under which a margin account operates and the additional risk you assume by choosing margin.
Federal Reserve Regulation T establishes the basic rules for engaging in margin trading. Currently, you must deposit 50% of the purchase cost of a security in your margin account. You must also maintain a minimum equity in your account (the market value of the securities minus the outstanding debit balance) of at least $2000 or 25% of the current market value of the securities, whichever is greater. An advantage of this method of trading is that $5,000 cash will allow you to purchase $10,000 in securities on margin. Buying on margin increases your potential for profit. Conversely, your risk of loss is greater as well. In addition, each month, your brokerage firm will charge you interest on the outstanding debit balance, much like on your credit card balance. The interest is added to your debit balance so the interest charges are compounded.
The brokerage firm will require you to sign a Margin Agreement which sets out the terms of the account. There are several significant terms which you should review in detail and understand. As was already mentioned, interest will be charged on the outstanding balance and the agreement will tell you how that interest is computed. The agreement will also give the brokerage firm permission to loan any of your stocks out to other customers. This does not change your ownership in any way but might affect you should the firm cease to do business. Another common clause requires you to settle any disputes concerning your account by arbitration rather than in court. Read this section carefully.
Perhaps one of the most important terms is one that causes confusion and concern in times of market declines. That is the right of the brokerage firm to sell securities to satisfy margin or maintenance calls. As noted above, you must maintain a minimum equity in your margin account at all times. While the minimum federal requirement is 25%, brokerage firms may set higher percentages based on the market price of individual securities in the account, the size of the account or other factors. If your account equity then falls below this "House" maintenance level, the brokerage firm will "call" for additional funds to bring your account back in line with the firms requirement. However, there is no specific time limit within which you are required to meet the call. In normal markets, calls are due in 3 to 5 business days and may be met by depositing additional funds or securities to your account. However, in more volatile markets, calls can be due in 1 day or less at the discretion of the brokerage firm. This is permitted to protect the brokerage firm from experiencing account value declines to the point where even after liquidating an account, an unsecured debit balance would still remain.
If the market value of the account goes back up before your call is due, most brokerage firms will not require you to meet the call. If your account value has not gone back up, however, and you have failed to deposit funds or securities by the required date, the brokerage firm is permitted to liquidate ANY securities in your account to satisfy the call. The firm may do so without regard to market price or any profit or loss to you. It may or may not send you a liquidation notice.
Brokerage firms are not responsible for the market performance of any securities in your account. Losing money on a securities investment does not necessarily indicate a violation of the securities law. Margin trading is risky. And margin trading in a volatile market is even riskier. Be sure you understand how margin accounts work before using one and know your responsibilities for maintaining that account in sound financial order.
If you feel you have a problem with any activity in your account, please contact the Department of Financial Institutions Division of Securities via the e-mail link on this web site or by calling 1-800-472-4325.