About Trading On Margin

Why Investors Buy On Margin

Buying securities on margin lets you increase your buying power. Margin allows you to buy more securities with less cash outlay. The result is greater potential profit - but also greater potential loss.

What Is Margin

When you buy securities on margin, you're using your own money to pay part of the purchase price and borrowing the rest of the purchase price from your brokerage firm. This lets you buy more securities than if you paid cash for the entire purchase.

Your brokerage firm uses your securities as collateral for the loan. When the securities decline in value, so does the collateral's value. If the securities decline substantially in value, the firm may ask for more collateral, or it may demand full or partial loan payment by issuing what's called a "margin call." Brokerage firms have the right to sell securities in your account to satisfy a margin call.

Should a brokerage firm issue a margin call, it may give you a very limited time to satisfy the call. This is particularly true if the markets are experiencing fast or unusually volatile conditions.

How A Margin Account Works

If you want to borrow funds from a brokerage firm, you'll first have to apply for a margin account. The firm will approve your application if you meet its credit standards. Some firms may also require you to have investment experience before opening a margin account. Once approved, you'll be able to begin buying securities on margin.

Whenever you buy securities on margin, you must deposit with your brokerage firm a portion of the security's purchase price. This is called the "initial margin requirement." This initial deposit is your account equity. Once you've made your purchase, you must maintain a certain minimum equity in your account. This is called the "maintenance margin requirement." We describe the initial margin requirements and maintenance margin requirements in more detail below.

Most stocks, but not all, can be purchased on margin. Those stocks that you can purchase on margin are called "marginable securities." Some stocks can't be purchased on margin, which means you can only purchase them in a cash account and you must deposit 100% of the purchase price.

Margin lending requirements, including the initial margin requirements and maintenance requirements, are set by federal regulation, the rules of the National Association of Securities Dealers, Inc. ("NASD"), and the securities exchanges. Brokerage firms may also set their own more stringent requirements.

Initial Margin Requirements

As a general rule, brokerage firms can lend up to 50% of a security's purchase price for a new purchase. You must have cash or other equity in your account to cover the remaining 50% of the purchase price.

Maintenance Margin Requirements

Your equity in a margin account at any given time is the difference between the market value of the securities and the loan amount. As a general rule, NASD and exchange rules state that your equity after the initial purchase must not fall below 25% of the current market value of the securities. If the market value of the securities decline - bringing your equity below 25% - you'll be required to deposit more funds or securities to restore your equity to at least 25%. If you fail to do so, the brokerage firm may sell the securities in your account as necessary to bring the account's equity back up to the required level.

Brokerage firms also have the right to set their own margin requirements - called "house" requirements. A firm's house requirements can be higher - but not lower - than the legal minimums. For example, a firm could have a minimum margin requirement of 30%. In this example, if the market value of the securities declines, brining your equity below 30%, you'd be required to deposit enough funds or securities to restore your equity to at least 30%. Some firms set higher margin requirements for certain stocks, such as volatile Internet stocks. A firm can change its margin requirements on a stock immediately and without advance notice, resulting in the issuance of a margin call. Again, your failure to satisfy the call may cause the firm to sell all or a portion of the securities in your account.

Example:

Let's assume you buy $50,000 of securities on Day 1. Federal regulations require you to deposit 50% of the purchase price, or $25,000, into your margin account. Your brokerage firm would loan you the remaining $25,000. As a result, your equity in the margin account is $25,000 on Day 1.

Assume that on Day 2 the market value of your securities declines to $30,000. Since you still have a margin loan of $25,000, your equity falls to $5,000 ($30,000 market value minus $25,000 loan). If your brokerage firm's maintenance margin requirement is 30%, your equity must not go below $9,000 ($30,000 market value multiplied by 30%). Under this scenario, you'd receive a margin call for $4,000 ($9,000 required equity minus your actual equity of $5,000). If you didn't meet the margin call, your firm would be required to sell enough of your securities to meet the margin call, which in this example (and because of the way the margin rules work) is approximately $13,400 worth of securities.

How Margin Calls Work In Volatile Markets

Normally, brokerage firms will calculate your margin equity based on the value of the securities as of the market close, and you may have several days to meet a margin call. The market close is currently 4:00 p.m., Eastern Time for most firms. But in volatile markets, firms may calculate your equity throughout the day.

For example, if your firm issues a margin call based on a stock's price as of the market close, and the stock continues to decline in value throughout the following day, the firm could sell your position anytime during the following day to prevent further losses. The firm may do so without giving you any further notice.

Trading on margin in volatile markets makes it more likely that you won't receive notice of a margin call if stock values drop significantly in a short period of time, and less likely that you'll have time to meet a margin call before the firm is forced to sell your securities.

To protect themselves in volatile markets, some people who buy on margin check the value of their positions throughout the day. Although this requires work, that may be necessary to avoid unmet margin calls and forced sales of your securities. You should never trade on margin unless you have access to sufficient funds to meet a margin call.

Partial Sell Outs

If you own the stocks of more than one company in your margin account and your firm issues a margin call that you fail to pay, your firm has the right to select which stocks it will sell to satisfy the margin call.

For example, in deciding which stock to sell your firm may consider it's aggregate margin exposure to a particular stock. If many of the firm's customers bought stock in a particular company, the firm may decide to sell your holdings of that company rather than some other stock in your margin account. It may for whatever reason be more advantageous from a tax standpoint if the firm sold your holdings of a different stock, but the firm is not required to consider tax consequences to you.

Margin And Your Credit

If you borrow money from a brokerage firm on margin, you should take the obligation as seriously as any loan you get from a bank or other lender. Failure to pay a margin loan, like any other loan, could result in legal action against you and jeopardize your credit rating. Make sure you have the financial wherewithal before buying any securities on margin.

Margin Agreements And Disclosures

If you buy securities on margin, your brokerage firm will charge you interest on the money you borrow. There may be additional fees and charges for borrowing on margin. Be sure to carefully review the margin agreement between you and your firm.

Managing A Margin Account

Trading securities on margin can be a profitable investment strategy, but it's important that you take the time to understand the risks.

• You could be required to deposit additional funds to meet a margin call.

If the value of the securities you bought on margin declines, you could be required to deposit additional funds in your margin account to avoid the forced sale of those or other securities.

• The securities in your account could be sold to meet a margin call.

If the equity in your account falls below your brokerage firm's maintenance margin requirements, the firm can sell the securities in your account to cover the deficiency. You may still be required to deposit additional funds in the account if there's a shortfall after the sale.

• Your brokerage firm is not required to consider your interests when selecting stocks to sell in a partial sellout.

Brokerage firms consider their own exposure to a particular stock when selecting which stocks to sell in a partial sell out. They don't consider what may be most advantageous to you from a tax standpoi

• You may not receive notice before your brokerage firms sells securities to meet a margin call.

Your brokerage firm is not required to contact you before selling your securities to meet a margin call. Although most firms attempt to reach their customers before selling securities to meet a margin call, they may not always be successful or there may not be sufficient time.

• You don't have a right to an extension to meet a margin call.

If you're unable to meet a margin call, you may be eligible for an extension in some cases. However, you're never entitled to an extension.

• Your credit could be affected if you are unable to pay your obligation to a brokerage firm.

Defaulting on a margin loan to a brokerage firm can have the same consequences as a default on any other kind of loan.

Understanding the risks of trading securities on margin is important. But it's also important to take steps to manage those risks.

• You should make sure you fully understand how your margin accounts work.

Be sure to read the margin agreement between you and your brokerage firm. Talk to your broker if you have any questions.

• You should know your brokerage firm's margin policies.

Firms can change their margin policies at any time, particularly during fast market periods. So you should speak with your broker or check your firm's web site for any changes in margin policies.

• You should always have a cash reserve in case you have to meet a margin call.

Your cash reserve should be readily accessible, such as a checking or short term savings account.

• You should monitor your margin equity on a regular basis.

You should consider monitoring your account throughout the day when the market is volatile

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