When the stock market quickly moves down, as it has been doing during the coronavirus market crash, you may find yourself in a situation where your stocks are sold to pay back a loan that a brokerage firm made to you. This is called a “margin call.”
A margin loan is a loan that the brokerage firm makes to you that is secured by the investments in your account. Some people do not even know that they have a margin in their brokerage account, and only first become aware of this fact when they are forced to pay a margin call or maintenance call. Many new account documents that you are asked to sign when you open a brokerage account allow for the securities firm to make a margin loan to you for the purchase of securities in your account. Therefore, you should review your brokerage account statements carefully to determine if you have a margin debit or a margin loan in your account.
The Securities and Exchange Commission has published an investor bulletin explaining to investors how margin accounts work.
The Difference Between Cash and Margin Accounts
A “cash account” is a type of brokerage account in which the investor must pay the full amount for securities purchased. An investor using a cash account is not allowed to borrow funds from his or her broker-dealer in order to pay for transactions in the account.
In contrast, a “margin account” is a type of brokerage account in which the broker-dealer lends the investor cash, using the account as collateral, to purchase securities. Margin increases investors’ purchasing power but also exposes investors to the potential for larger losses.
You Should Understand How Margin Works
Margin loans are a tool that allows customers to leverage their accounts to make a greater return. Let’s say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you’ll earn a 50 percent return on your investment (your $25 gain is 50% of your initial investment of $50). But if you bought the stock on margin – paying $25 in cash and borrowing $25 from your broker – you’ll earn a 100 percent return on the money you invested (your $25 gain is 100% of your initial investment of $25). You may also owe your broker interest on the $25 you borrowed.
There is a downside to using margin, which is riskier than a cash account. If the stock price decreases, you can quickly lose your money. For example, let’s say the stock you bought for $50 falls to $25. If you fully paid for the stock, you’ll lose 50 percent of your money (your $25 loss is 50% of your initial investment of $50). But if you bought on margin, you’ll lose 100 percent (your $25 loss is 100% of your initial investment of $25), and you still must come up with the interest you owe on the loan. Many investors cannot afford to takes this type of gamble with their funds.
Your Brokerage Firm May Sell Your Stock to Cover a Margin Call Without Notice to You
Some investors have been shocked to find out that their brokerage firm has the right to sell their securities that were bought on margin – without any notification to them and potentially at a substantial loss. If your broker sells your stock after the price has plummeted, then you’ve lost out on the chance to recoup your losses if the market bounces back. You may also suffer additional losses in that you have to pay back the loan and may not be able to get the benefit of any of the proceeds from the forced sale.
Buying or Holding Stocks Using Margin Loans Is not Suitable for Everyone
For people with limited financial means or those who are retired and living on a fixed income, investing in securities using margin may not be a suitable investment strategy. You should ask your broker whether trading on margin is appropriate for you in light of your financial resources, investment objectives, and tolerance for risk.
Read Your Margin Agreement
In many cases when you open a brokerage account, the margin agreement may be part of your general brokerage account opening documents although it may also be a separate agreement. The margin agreement states that you must abide by the margin requirements established by the Federal Reserve Board, FINRA, any applicable securities exchange, and the firm where you have set up your margin account. Be sure to carefully review the agreement before you sign it.
Just like other loans you may have taken, the margin agreement explains the terms and conditions of the margin account. For example, the agreement describes how the interest on the loan is calculated, how you are responsible for repaying the loan, and how the securities you purchase serve as collateral for the loan. Carefully review the agreement to determine what notice, if any, your firm must give you before either selling your securities to collect the money you have borrowed or made any changes to the terms and conditions under which interest is calculated. In general, a firm must provide a customer at least 30-days written notice of changes in the method of computing interest.
Margin Loans for Non-Securities Purposes
In addition to buying stock, some brokers may allow you to use margin loans for a variety of other financial reasons, such as buying real estate, paying off personal credit, or providing business capital. These are also known as securities backed lines of credit or SBLOCs. Using margin loans for non-securities purposes DOES NOT change how these loans work. Margin loans are still secured by the securities in your margin account and carry the same risks associated with purchasing securities on margin.
FINRA has published additional risks to investors who trade using margin loans:
- You can lose more funds than you deposit in the margin account. A decline in the value of securities that are purchased on margin may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securities in your account.
- The firm can force the sale of securities in your account. If the equity in your account falls below the maintenance margin requirements under the law—or the firm’s higher “house” requirements—the firm can sell the securities in your account to cover the margin deficiency. You will also be responsible for any shortfall in the account after such a sale.
- The firm can sell your securities without contacting you. Some investors mistakenly believe that a firm must contact them for a margin call to be valid and that the firm cannot liquidate securities in their accounts to meet the call unless the firm has contacted them first. This is not the case. As a matter of good customer relations, most firms will attempt to notify their customers of margin calls, but they are not required to do so.
- You are not entitled to an extension of time on a margin call. While an extension of time to meet initial margin requirements may be available to customers under certain conditions, a customer does not have a right to the extension. In addition, a customer does not have a right to an extension of time to meet a maintenance margin call.
- Open short-sale positions could cost you. You may have to continue to pay interest on open short positions even if a stock is halted, delisted, or no longer trades.
As you can see, the use of margin can be risky and is not appropriate or suitable for everyone.
If you believe that you or a loved one has been harmed by investing on margin or by any other type of investment fraud or investment scam, contact our offices today for a free consultation. Former Wall Street securities attorney Melanie S. Cherdack and her team of lawyers will evaluate your claim at no cost to you. Contact us by filling out our online contact form, or calling 888-768-2499 or 305-349-2336.