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NEWSLETTERS & ALERTS
Investments - Strategies
Investing with Borrowed Funds: Less ‘Margin’ for Error
by Howard Haykin
That scenario plays out every day in brokerage firms, so it’s not surprising that, for the first 10 months of 2019, investor purchases of securities “on margin” averaged more than $592 billion. The statistic was captured by the Financial Industry Regulatory Authority, or FINRA, prompting concern that many investors may underestimate the risks of trading on margin – and misunderstand the operation of and reason for, margin calls. Investors who cannot satisfy margin calls can have large portions of their accounts liquidated under unfavorable market conditions. These liquidations can create substantial losses for investors.
CASH ACCOUNT vs MARGIN ACCOUNT. Cash brokerage accounts get their name from the fact that all transactions in the brokerage account have to be done with the funds that are available at the time of the transaction. When you buy a stock, you need to pay for the stock in time for the trade to settle. Many brokers go a step further, requiring you to have the cash in your account when you execute your trade. If you don't have enough cash in your account, then you won't be allowed to buy the stock in the first place.
Margin accounts, by contrast, involve entering into a credit arrangement with your broker. You can use the margin that a margin account offers in several different ways – but individual investors most commonly use margin accounts to borrow against the value of their stocks and other investments to make further asset purchases. This essentially gives them leverage with their investments, because they can buy more stock through borrowing than they'd be able to buy just with their available cash.
DANGERS OF MARGIN ACCOUNTS. Let's use our opening examples, where you bought stock for $100 a share. Let's now consider what happens if the stock suddenly plunges to $50 per share.
In the cash account, your 100 shares of stock are now worth $5,000 instead of $10,000. But because you had the cash upfront to purchase the stock, that's the full extent of your losses. However, in the margin account where you bought 200 shares by taking out a margin loan of $10,000, you have much bigger problems.
First, because you owned twice as much stock, your losses are twice as big, at $10,000 rather than $5,000. Even worse, your broker will look at your account and see that you owe a $10,000 margin loan on assets that are now worth only $10,000. In response, the broker will demand that you add more cash to your brokerage account in order to provide protection from further stock price declines. However, if you don't, then your broker will sell your stock at $50 per share, locking in your losses and taking away any chance that you can recover what you've lost if the stock rebounds.
FINRA ISSUES INVESTOR ALERT. The above summaries and scenarios demonstrate why FINRA issued an Investor Alert, cautioning investors to make sure they understand the following risks before opening a margin account,:
- Your firm can force the sale of securities in your accounts to meet a margin call.
- Your firm can sell your securities without contacting you.
- You are not entitled to choose which securities or other assets in your accounts are sold.
- Your firm can increase its margin requirements at any time and is not required to provide you with advance notice.
- You are not entitled to an extension of time on a margin call.
- You can lose more money than you deposit in a margin account.
[For further discussion about Cash and Margin Accounts, click on The Motley Fool article.]
[For further discussion re: Purchasing on Margin and the Inherent Risks, click on FINRA Guidance.]