Investor Bulletin: Understanding Margin Accounts

The SEC’s Office of Investor Education and Advocacy is issuing this Investor Bulletin to educate investors about the use of margin accounts to buy securities and their related risks.

The Difference Between Cash and Margin Accounts

A “cash account” is a type of brokerage account in which you must pay the full amount for securities purchased.  In a cash account you cannot borrow funds from your broker-dealer to pay for transactions in the account.  A “margin account” is a type of brokerage account in which your broker-dealer lends you cash, using the account as collateral, to purchase securities (known as “margin securities”).  Brokerage firms may allow you to have both a margin account and a cash account at the same time.

IMPORTANT: WHEN OPENING A BROKERAGE ACCOUNT, SOME BROKERAGE ACCOUNT APPLICATIONS MAKE MARGIN ACCOUNTS THE DEFAULT ACCOUNT TYPE.  CONFIRM YOU ARE OPENING THE ACCOUNT TYPE YOU WANT BEFORE YOU SIGN YOUR ACCOUNT APPLICATION.

Margin increases your purchasing power, but also exposes you to the potential for larger losses.  Here’s what you need to know about margin.

Understand How Margin Works

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 (i.e., 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 (i.e., your $25 gain is 100% of your initial investment of $25).*  

*For simplicity, this example does not account for the interest you would owe your broker on the $25 margin loan you used to buy this stock. After paying this interest to your broker, your actual return would be slightly less than 100%.

The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let’s say the stock you bought for $50 falls to $15.  If you fully paid for the stock, you would lose 70 percent of your money.  However, if you bought on margin, you would lose more than 100 percent of your money. In addition to the 100% loss of your $25 initial investment, you would also owe your broker an additional $10 plus the interest on the margin loan.

Investors who put up an initial margin payment for a stock may, from time to time, be required to provide the broker with additional cash or securities if the price of the stock falls (a “margin call”).  Some investors have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin – without any notification and potentially at a substantial loss to the investor.  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.

Recognize the Risks

Margin accounts can be very risky and they are not appropriate for everyone. Before opening a margin account, you should fully understand that:

  • You can lose more money than you have invested;
  • You may have to deposit additional cash or securities in your account on short notice to cover market losses;
  • You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities;
  • Your brokerage firm may sell some or all of your securities without consulting you to pay off your margin loan;
  • You are not entitled to choose which securities your brokerage firm sells in your accounts to cover your margin loan;
  • Your brokerage firm can increase its margin requirements at any time and is not required to provide you with advance notice; and
  • You are not entitled to an extension of time on a margin call.

You can protect yourself by:

  • Knowing how a margin account works and what happens if the price of the securities purchased on margin declines.
  • Understanding that your broker charges you interest for borrowing money and how that will affect the total return on your investments.
  • Being aware that not all securities can be purchased on margin.
  • Asking 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

To open a margin account, your broker will have you sign a margin agreement.  The margin agreement may be part of your general brokerage account opening agreement or may be a separate agreement.  

The margin agreement states that you must abide by the margin requirements established by the Federal Reserve Board, self-regulatory organizations (SROs) such as 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.

As with most loans, 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 making 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.

Know the Margin Rules

The Federal Reserve Board, SROs such as FINRA and the securities exchanges, have rules that govern margin trading.  Brokerage firms can establish their own “house” requirements that are more restrictive than those rules.  Here are some of the key rules you should know:

Before You Trade – Minimum Margin

Before trading on margin, FINRA, for example, requires you to deposit with your brokerage firm a minimum of $2,000 or 100 percent of the purchase price of the margin securities, whichever is less.  This is known as the “minimum margin.”  Some firms may require you to deposit more than $2,000.

Amount You Can Borrow – Initial Margin

According to Regulation T of the Federal Reserve Board, you may borrow up to 50 percent of the purchase price of margin securities.  This is known as the “initial margin.”  Some firms require you to deposit more than 50 percent of the purchase price.

Amount You Need After You Trade – Maintenance Margin

After you buy margin securities, FINRA rules require your brokerage firm to impose a “maintenance requirement” on your margin account.  This “maintenance requirement” specifies the minimum amount of equity you must maintain in your margin account at all times.  The equity in your margin account is the value of your securities less how much you owe to your brokerage firm.  FINRA rules require this “maintenance requirement” to be at least 25 percent of the total market value of the margin securities.  However, many brokerage firms have higher maintenance requirements, typically between 30 to 40 percent, and sometimes higher depending on the type of securities purchased.

Here’s an example of how maintenance requirements work.  Let’s say you purchase $16,000 worth of securities by borrowing $8,000 from your firm and paying $8,000 in cash or securities.  If the market value of the securities you purchased drops to $12,000, the equity in your account will fall to $4,000 ($12,000 – $8,000 = $4,000).  If your firm has a 25 percent maintenance requirement, you must have $3,000 in equity in your account (25 percent of $12,000 = $3,000).  In this case, you do have enough equity because the $4,000 in equity in your account is greater than the $3,000 maintenance requirement.

But if your firm has a maintenance requirement of 40 percent, you would not have enough equity.  The firm would require you to have $4,800 in equity (40 percent of $12,000 = $4,800).  Your $4,000 in equity is less than the firm’s $4,800 maintenance requirement.  As a result, the firm may issue you a “margin call” to deposit additional equity into your account since the equity in your account has fallen $800 below the firm’s maintenance requirement.

Special Considerations for Margin Accounts

Understand Margin Calls – You Can Lose Your Money Fast and With No Notice

If your account falls below the firm’s maintenance requirement, your firm generally will make a margin call to ask you to deposit more cash or securities into your account.  When a margin call occurs you generally cannot purchase any additional securities in your account until you satisfy the margin call requirements. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm’s maintenance requirement.

However, your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm’s maintenance requirement.  Your broker may be able to sell your securities at any time without consulting you first.  Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.

Options Trading Using Margin

Using margin to trading options may expose you to significant investment risks. Brokerage firms generally require you to have a margin account to trade options, but they do not allow you to use margin to purchase options contracts.  However, brokerage firms may allow you to use margin to sell (or write) options contracts. Options strategies that involve selling options contracts may lead to significant losses and the use of margin may amplify those losses. Some of these strategies may expose you to losses that exceed your initial investment amount (i.e., you will owe money to your broker in addition to the investment loss). For additional information on options trading using margin please read our Investor Bulletin “Leveraged Investing Strategies – Know the Risks Before Using These Advanced Investment Tools.”

Interest Charges – Money is not free

Like all loans, margin loans charge interest. This interest directly reduces your return on investments, increasing the amount your investment needs to earn to break even. Interest rates can vary substantially between brokerage firms. Remember to carefully consider this expense before opening any margin account.

Account Transfers

If you plan to transfer securities from a margin account to another brokerage firm make sure you               understand your current brokerage firm’s rules for transferring securities out of these accounts. Many firms will not allow you to transfer any securities out of a margin account if the account has an outstanding margin loan. These rules are generally included in your account agreement or a separate margin agreement you signed when opening the margin account. Ask your current firm to provide and explain these rules to you before initiating a transfer of securities from a margin account. For additional information on account transfers, please read our Investor Bulletin: Transferring Your Investment Account.

Margin in Fee-Based Accounts

Instead of charging for individual transactions, some investment accounts charge an asset-based fee (annually, quarterly or monthly) equal to a percentage of the market value of the securities in the account. If you use margin to purchase securities in these accounts, remember that the asset-based fee is typically based on the value of all securities in the account and does not account for the debt used to purchase margin securities.

Margin Loans – Carefully Consider the Risks of Using Margin Loans for Non-Securities Purposes.

In addition to purchasing securities, some brokers may allow you to use margin loans for a variety of personal or business financial purposes, such as buying real estate, paying off personal credit, or providing capital.  Using margin loans for non-securities purposes DOES NOT change the way these loans work.  These loans are still secured by the securities in your margin account and thus subject to the same risks associated with purchasing securities on margin described above.  The terms and conditions of these loans vary between brokers and are generally specified in the margin agreement.  You should carefully consider the margin risks described above as well as any fees which may be associated with these loans before using them for any non-securities purpose.

Securities Lending

Some margin accounts allow the brokerage firm to lend out securities in the account to a third-party, at any time without notice or compensation to the account holder, if the investor has any outstanding margin loan in the account. While shares are lent out, you may lose the voting rights associated with those shares. You will still receive a payment for any dividends related to lent out shares.  However, since you are not the official holder of the shares, the payment you receive may be taxed differently. Ask your brokerage firm if its margin accounts allow for securities lending, and if so, to explain how it works and may impact the securities in the account. 

Pattern Day Trader Margin Requirements

For a customer that is a “pattern day trader,” FINRA requires that the broker impose special margin requirements on the customer’s margin account.  In general, these include an increased minimum equity requirement of $25,000 and a restriction that caps the purchasing power in the margin account at four times the maintenance margin excess as of the close of business of the previous day for equity securities.  For additional information on these “pattern day trader” margin requirements, please read our Investor Bulletin: Margin Rules for Day Trading.

Additional Resources

Investor Bulletin “Leveraged Investing Strategies – Know the Risks Before Using These Advanced Investment Tools.”

For additional information on margin rules for day traders, please read our Investor Bulletin: Margin Rules for Day Trading.

FINRA margin account information:

FINRA’s Investor Alert “Investing with Borrowed Funds: No “Margin” for Error,”

FINRA Investor Insights: “Know What Triggers a Margin Call”

FINRA’s investor bulletins “Purchasing on Margin, Risks Involved with Trading in a Margin Account” and “Understanding Margin Accounts, Why Brokers Do What They Do

SEC Division of Economic and Risk Analysis White Paper “The Financial Illiteracy and Overconfidence of Margin Traders.”

For additional investor education information, see the SEC’s website for individual investors, Investor.gov.

Call OIEA at 1-800-732-0330, ask a question using this online form, or email us at [email protected].

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Key Questions You Should Consider Before Buying Securities in a Margin Account

  • Do you know that margin accounts involve a great deal more risk than cash accounts where you fully pay for the securities you purchase?
  • Are you aware you may lose more than the amount of money you initially invested when buying on margin?
  • Can you afford to lose more money than the amount you have invested?
  • Did you take the time to read and understand the margin agreement?
  • Did you ask your broker questions about how a margin account works and whether it’s appropriate for you to trade on margin?
  • Did your broker explain the terms and conditions of the margin agreement?
  • Are you aware of the costs you will be charged on money you borrow from your firm and how these costs affect your overall return?
  • Are you aware that your brokerage firm can sell your securities without notice to you when you don’t have sufficient equity in your margin account?

This Investor Bulletin represents the views of the staff of the Office of Investor Education and Advocacy.  It is not a rule, regulation, or statement of the Securities and Exchange Commission (“Commission”).  The Commission has neither approved nor disapproved its content.  This Investor Bulletin, like all staff guidance, has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person.

Source: SEC

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