Risk is the engine of the stock market. Without risk, there would be no way to make money as your stock prices rise. Of course, the same risk that inflates stock prices one day can deflate them the next. For the average stock market investor, the normal risk of the market is enough to satisfy their financial goals without keeping them up at night. But for high-rolling investors who want to make large amounts of money quickly -- and fully understand the serious risks involved -- nothing beats buying on margin.
Buying on margin is borrowing money from your stockbroker to buy stock. Essentially, it's a loan from your broker [source: Investopedia]. Here's an example of how buying on margin works: Your broker can loan you up to 50 percent of the price of a stock. So if the stock price is $100,000, you'll only have to pay $50,000 and your broker will cover the other $50,000. If the stock price increases to $125,000, you make a 50 percent return on your investment! But if the stock price drops to $75,000, you've lost 50 percent of your investment -- and you owe interest on the loan (currently 2 percent) from your broker, plus charges and fees [source: Bankrate.com].
Buying on margin is deeply risky. You not only have the potential of losing your entire investment plus interest, but losing even more money through something called a margin call. To have a margin account, the Federal Reserve Board requires that you always have enough money in your account to cover the maintenance margin. At a minimum, you must have enough cash (equity) in your margin account to equal 25 percent of the total price of the stock you own. If you don't have enough cash in the account, your broker can issue a margin call requiring you to deposit enough money to reach the 25 percent maintenance level.
Using our example above, if you buy $100,000 of stock on margin, you only need to pay $50,000. Seems like a great deal, especially if the stock price goes up. But what if your stock drops to $60,000? Suddenly, you've lost $40,000, leaving you with only $10,000 in your margin account. The rules state that you need to have at least 25 percent of the $60,000 stock value in your account, which is $15,000. So not only do you lose $40,000, but you have to deposit an additional $5,000 in your margin account to stay in business.
In the next section, we'll read the fine print about margin calls and discover why they can be so dangerous to investors.
Margin Call Rules and Regulations
The U.S. Securities and Exchange Commission (SEC) cautions investors to read their margin account agreements very carefully. No one should enter a margin relationship with a broker without reading the fine print and fully understanding the risks of buying stock with other people's money.
For example, the Federal Reserve Board sets the basic rules of buying stock on margin. However, each broker has its own house requirements that may be even stricter and more potentially damaging to margin investors [source: FINRA]. For example, Federal Reserve Board Regulation T states that investors need to maintain at least 25 percent equity in their margin account, but some brokers will require at least 30 percent, depending on the risk and value of the stock being purchased [source: FINRA]. Anything less than that amount and the broker will issue a margin call for the difference.
The most surprising fact about margin calls for many new investors is that your broker is not required by law to notify you that your margin account is too low [source: SEC]. Instead, your broker can just sell your stock (liquidate your assets) to reach the maintenance level in your account. Even if your broker issues a margin call, it can start selling your stock while it waits for you to make a deposit [source: SEC]. The forced liquidation of stock is so painful because it erases the possibility of making your money back when or if the market turns around.
Other fine-print surprises about margin calls:
- You can't choose which stocks your broker sells to reach the maintenance margin.
- Your brokerage firm can change is house requirements anytime it wants and issue a margin call based on the new rules.
- You have no right to a time extension to pay your margin call. [source: FINRA]
The bottom line for investors is to avoid margin calls at all costs. The best way to do that is to closely monitor your investments to make sure you have plenty of money in your margin account to cover the maintenance requirement, whether it's 25 percent or higher. This requires a second cash account from which you can quickly and easily transfer money into the margin account.
For lots more information on investing, follow the links on the next page.
More Great Links
- Bankrate.com. "Call Money" (Accessed Sept. 24, 2011) http://www.bankrate.com/rates/interest-rates/call-money.aspx
- Blumenthal, Karen. The Wall Street Journal Classroom Edition. "Seeds of the 1929 Crash." November 2002 (Accessed Sept. 24, 2011) http://www.wsjclassroomedition.com/archive/02nov/ECON3.htm
- Financial Industry Regulatory Authority. "Investing with Borrowed Funds: No 'Margin' for Error" (Accessed Sept. 23, 2011) http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/MarginAndBorrowing/P005973
- Investopedia. "Margin Trading Tutorial" (Accessed Sept. 23, 2011) http://www.investopedia.com/university/margin/margin1.asp#axzz1Z3wRYH4X
- U.S. Securities and Exchange Commission. "Margin: Borrowing Money to Pay for Stocks" (Accessed Sept. 24, 2011) http://www.sec.gov/investor/pubs/margin.htm