Unexpected Losses due to Margin

Margin is borrowing money from a broker in order to buy a stock and then using the original investment as collateral. Investors generally use margin in order to increase their purchasing power so that they can own more stock without actually fully paying for it. The use of margin exposes the investors to the potential for higher losses.

In many cases, the use of margin may not always be suitable for the client. The broker must make recommendations which are consistent with the customer’s needs, risk tolerance, overall investment objectives and goals and the financial ability. The broker has a duty to know their clients and to recommend trading strategies and investments that are suitable for the individual. Margin trading may not be suitable if a customer does not have the financial resources in order to incur the risk which is associated with a particular investment, if the customer did not understand or know all of the risks which were associated with certain investments or if the investment was not in line with the financial objectives of the investor.

Client’s agreement and prior approval in writing is required before the establishment of a margin account. As specified in Regulation T of the Board of Governors of the Federal Reserve System, the customer must receive in writing or electronically, individually, and in a separate document, a margin disclosure statement, for or on behalf of customer, before opening a margin account. In addition, the interest charges which are associated with the borrowing of money in the margin account must also be clearly defined. At times, the interest rates that are associated with the use of a margin may be considerably higher than the interest rates from other sources.

It is the duty of the broker to understand the tax considerations for the client, risk tolerance of an investor, the client’s prior experiences and the level of return desired and appetite for risk. It is the broker’s duty to make recommendations that are appropriate and suitable given his client’s circumstances. If margin trading is not suitable for a client, the broker may be liable to that client, just because margins significantly increase the risks involved with investing in securities and frequently those increased risks are not always adequately explained to the client.

Some of the “red flags” which may indicate that margin use was inappropriate are as follows:

• A debit balance or a margin loan balance which appears on a statement unexpectedly.

• The margin account is used to purchase extremely or speculative volatile securities.

• The margin account is used like a line of credit.

• A margin account is opened in an IRA or retirement trading account.

The broker is entitled to and has every right to sell the securities without obtaining permission or without contacting the client, if a client has a margin account, and the equity level which is the value of the securities minus what is owed to the broker in the account falls below the maintenance margin requirements of the brokerage firm’s. The amount a client needs to maintain after trades is called the maintenance margin. These amounts are set by the individual brokerages as well as by the Federal Reserve Board. The Federal Reserve Board sets a minimum initial margin which is of 50% and a maintenance margin of at least 25%, even though individual brokerages may have stricter limits.

The actions which were undertaken from the broker in order to return the account to a minimum maintenance requirement should be spelled out in the margin account agreement which was signed when the account was opened. To ensure that the brokerage firm receives the money which was borrowed, the broker will liquidate or sell the account’s securities regardless of whether the money is lost on the trades. A strict method may not necessarily be used by the broker when picking the stocks to sell out of the account. Instead, the stocks are sold solely to cover the entire deficit in the equity level and may for example be picked in an alphabetical order. In addition, the broker may even charge full commissions for the transactions upon selling the securities. There may also be negative tax implications for the investor by the sale of these stocks.

Margin accounts are not suitable for everyone and can be very risky. Before opening a margin account, the investor should fully understand that:

• More money, than originally invested, can be lost.

• Additional cash may need to be deposited into the account, on a short notice, in order to cover the market losses.

• When falling stock prices reduce the value of the securities, some or all of the securities may need to be sold.

All of the risks associated with margin accounts need careful consideration.