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 below.
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