Margin Trading

Borrowing can increase gains, but it increases losses too, and you can lose more than you put in. If the value of the account falls, the firm can demand more money or sell your securities, sometimes without notice. Losing money on margin is not, by itself, a claim. The key questions are whether borrowing fit the investor and whether the professional who recommended or approved it fulfilled their duties.

This May Not Be Your Fault

A margin account often opens with a stack of paperwork, and many investors sign it without realizing what it allows. If you did not fully understand that you were borrowing, or what could happen if prices fell, you are far from alone.

That is why the rules put duties on the firm. Under FINRA Rule 2264, a firm must give an individual investor a separate margin disclosure statement before opening a margin account, and again at least once a year. A broker who recommends borrowing must also have a reasonable basis to believe it serves your best interest under Regulation Best Interest, which means weighing your finances, your goals, and your ability to absorb a loss. When that does not happen, responsibility may belong with the broker and the firm.

How Margin Trading Works and What Makes It Risky

The SEC’s publication Margin: Borrowing Money to Pay for Stocks explains that federal rules generally let you borrow up to half of the purchase price of securities bought on margin. After that, FINRA rules require the equity in your account, meaning the value of your securities minus what you owe, to stay at or above 25 percent of their market value. Many firms set a higher level, often 30 to 40 percent. If your equity falls below the firm’s requirement, you face a margin call, a demand for more cash or securities.

FINRA’s margin disclosure statement spells out what can go wrong:

• You can lose more than you deposit. You may owe the firm more than the money you put into the account.
• The firm can sell without calling you. It can sell your securities without contacting you first, even after it has issued a margin call with a deadline.
• You do not choose what gets sold. The firm decides which holdings to sell, because they are its collateral.
• The rules can change without notice. A firm can raise its own requirements at any time, often with immediate effect.
• You have no right to more time. A firm may sometimes grant an extension, but you are not entitled to one.

Margin also costs money. Like any loan, it charges interest, and that cost continues whether or not your investments gain. The SEC notes that you may be forced to sell some or all of your securities just when falling prices have reduced their value, so a loss can become permanent.

Hypothetical illustration: a retiree borrows on margin to buy more of a stock already held in the account. When the price drops, the firm sells shares to cover the loan, and the retiree ends up with a loss larger than the original deposit and a balance still owed.

Under Regulation T, you generally must put up 50 percent of the purchase price of a margin purchase, and FINRA requires you to keep equity of at least 25 percent in the account. Firms can set higher requirements, and, as FINRA explains, a firm can sell your securities without notice.

Common Examples of Margin Trading Claims

• Margin recommended to a retiree or conservative investor whose goals did not call for borrowing — see Unsuitable Recommendations
• A margin account opened without a clear explanation that losses could exceed the investor’s deposits, or that securities could be sold without notice — see Misrepresentation and Omission
• A large share of a margin account placed in one stock or sector, so a single decline triggered calls and sales — see Overconcentration
• Frequent trading on borrowed funds that generated commissions and interest while the account lost value — see Churning
• Trades placed on margin without the investor’s permission — see Unauthorized Trading
• A firm that allowed a heavily borrowed, concentrated account to continue without review — see Failure to Supervise
• Securities sold in a way that may not have followed the firm’s own agreement or margin-call procedures — see Breach of Contract
• A loan against a portfolio, rather than a margin loan, described as low-risk without an honest explanation of the downside — see Securities-Backed Lines of Credit and our article Don’t Borrow Trouble

How Can You Protect Yourself From Margin Trading Losses?

Margin is not off limits, but it calls for more questions than an ordinary account does. A few steps that help:

• Read the margin agreement before you sign. The SEC advises reading it carefully first, because it sets out how interest is calculated and what notice, if any, you will receive before securities are sold.
• Ask how much you could lose and owe. Ask whether you could end up owing more than you deposited, and have the answer in plain words.
• Ask what happens if prices fall. Find out at what level you would get a margin call, how fast you would need to respond, and whether the firm could sell first.
• Ask what the loan costs. Get the interest rate in writing and ask what you would pay in a year if the balance stays the same.
• Check how much is borrowed and how much is in one holding. Borrowing against a single stock or a few stocks leaves little room for a decline.

Signs Your Margin Trading May Have Been Unsuitable

• You did not know your account allowed borrowing, or do not remember agreeing to it
• No one explained that you could lose more than you put in
• Securities were sold from your account with little or no warning
• A margin call came on short notice, at a time you could not meet it
• After the sales, you still owed the firm money
• Interest charges took a large share of any gains
• A large part of your account was in one or two stocks bought with borrowed money
• Your account showed heavy trading on borrowed funds
• You were retired or close to retirement and your goals called for safety or steady income