Like the stock market, margin debt has risen sharply in recent months. According to FINRA's latest margin statistics, borrowing by investors in November 2017 stood at an all-time high of $627.4 billion. This is almost a $100 billion increase over margin borrowing at the end of 2016 -- and more than double the level of borrowing at the end of 2010.
FINRA often gets phone calls from investors after they receive a margin call, which is essentially a demand by your firm for the repayment of your margin debt. Now, in the midst of a bull market, is a good time to get ahead of things. In the event you get a margin call from your brokerage firm, are you prepared?
Preparation starts with knowing the risks associated with buying securities on margin, but first a few basics.
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Margin account basics
Buying on margin is basically getting a loan from your firm to buy securities. When you buy securities on margin, you must repay both the amount you borrowed and interest, even if you lose money on your investment. Some brokerage firms automatically open margin accounts for investors. While the ability to trade on margin could be useful to some investors, a margin account may or may not be right for you. Make sure you understand what type of account you have and, if you don't want to trade on margin, consider choosing a cash account for your transactions. For information on how margin works, see FINRA's investor alert Investing with Borrowed Funds: No "Margin" for Error.
Margin trading risks
Before you take on margin debt to buy securities, here are eight risks you should know:
- Your firm can force the sale of securities in your accounts to meet a margin call. If the equity in your account falls below the maintenance margin requirements under the law -- or the firm's higher "house" requirements -- your firm can sell the securities in your accounts to cover the margin deficiency. You will also be responsible for any shortfall in the accounts after such a sale.
- Your firm can sell your securities without contacting you. Some investors mistakenly believe that a firm must contact them first for a margin call to be valid. This is not the case. Most firms will attempt to notify their customers of margin calls, but they are not required to do so. Even if you're contacted and provided with a specific date to meet a margin call, your firm may decide to sell some or all of your securities before that date without any further notice to you. For example, your firm may take this action because the market value of your securities has continued to decline in value.
- You are not entitled to choose which securities or other assets in your accounts are sold. There is no provision in the margin rules that gives you the right to control liquidation decisions. Your firm may decide to sell any of the securities that are collateral for your margin loan to protect its interests.
- Your firm can increase its "house" maintenance requirements at any time and is not required to provide you with advance notice. These changes in firm policy often take effect immediately and may cause a house call. If you don't satisfy this call, your firm may liquidate or sell securities in your accounts.
- You are not entitled to an extension of time on a margin call. While an extension of time to meet a margin call may be available to you under certain conditions, you do not have a right to the extension.
- You can lose more money than you deposit in a margin account. A decline in the value of the securities you purchased on margin may require you to provide additional money to your firm to avoid the forced sale of those securities or other securities in your accounts.
- Open short-sale positions could cost you. You may have to continue to pay interest on open short positions even if a stock is halted, delisted, or no longer trades.
Action steps
Given the significant risks associated with margin, make sure you fully understand how a margin account works before making investments. Reread your firm's margin agreement and consult with your broker about any questions or concerns you may have with your margin account.
Monitor the price of the securities in your margin account on a daily basis. If you see that the securities in your account are declining in value, you may want to consider depositing additional cash or securities to attempt to avoid a margin call. If you receive a margin call, act promptly to satisfy the margin call. By depositing cash or selling securities that you choose, you may be able to prevent your firm from liquidating or selling securities it chooses.
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