Tuesday, May 15, 2018 10,30AM / US SEC
The SEC’s Office of Investor Education and Advocacy is publishing this Investor Bulletin to educate investors about the use of margin accounts to buy securities, including the related risks.
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.
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. 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 (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.
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 $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.
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, understand that:
You can protect yourself by:
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, 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, self-regulatory organizations (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 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 equity securities that can be purchased on margin. 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 stock on margin, 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 securities purchased on margin (that is, “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.
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.
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. 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.
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.
· For additional information on margin rules for day traders, please read our Investor Bulletin: Margin Rules for Day Trading.
· For FINRA’s resources related to margin accounts, please read FINRA’s Investor Alert “Investing with Borrowed Funds: No “Margin” for Error,” and 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.”
Key Questions You Should Consider Before Buying Securities in a Margin Account
The Office of Investor Education and Advocacy has provided this information as a service to investors. It is neither a legal interpretation nor a statement of SEC policy. If you have questions concerning the meaning or application of a particular law or rule, please consult with an attorney who specializes in securities law.