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Buying securities on margin in an investment account enables the account holder to use the securities and cash in their account as collateral to borrow money from the brokerage firm to buy more securities. Both the risk of loss and potential gains increase as margin debt increases. If the securities used as collateral decrease in value, the brokerage firm can issue a margin call, requiring you to repay all or part of the loan, along with interest. In recent years, some firms have opened margin accounts for their customers by default. For example, some new account forms contain the following boiler-plate language, often in very small print:
All qualified accounts are opened as margin accounts. Margin trading entails greater risk and is not suitable for all investors. If the market value of eligible securities in your account declines, you may be required to deposit more money or eligible securities in order to maintain your line of credit. By signing below, I acknowledge that I have received and read the General Account Agreement and Disclosure Document…[i]
Always read the fine print
In order to decline margin "privileges," an investor sometimes must check a box that states, "I/We decline margin privileges. Please open my account as a cash account only." Investors need to be cautious – if you do not want margin in your account, make sure that you open your account as a "cash" account only, and don't borrow money from the firm. If your stockbroker fills out the new account agreement for you and asks you to sign it, take the time to review the application thoroughly. Never sign any document unless you review and understand it and agree with the information contained therein, especially when that document may authorize margin trading in your account. Margin trading increases the risk in an account significantly. If you are a conservative investor or are concerned with preserving your principal, you probably should not trade on margin in your account. Margin trading is more suitable for sophisticated investors, not the average investor seeking to minimize market risk.
The Federal Reserve Board, the Financial Industry Regulatory Authority ("FINRA"), the Securities and Exchange Commission ("SEC") and securities exchanges like the New York Stock Exchange ("NYSE") regulate margin trading. Federal Reserve Board "Regulation T" places limits on the amount investors may margin particular investments (click here for the full text of "Regulation T"). In addition, FINRA Rule 2520 and NYSE Rule 431 require that the equity in an investor's account not drop below a certain percentage of the current market value of the securities being used as collateral.[ii] If this occurs, brokerage firms issue a "maintenance margin call" requiring the investor deposit more funds or securities to make up the shortfall.
Brokers are required to disclose certain risks to you associated with margin trading
If the equity in your account falls below the margin maintenance requirement, the brokerage firm may liquidate the securities in your account to cover the margin deficiency without contacting you. They need not consult with you regarding which securities in your account are liquidated to meet the margin call. For example, if you have blue chip stocks in your account along with lower rated stocks, the firm may sell your blue chip stocks without consulting you and leave you with the lower rated stocks. Brokerage firms can also increase their own "house" margin maintenance requirements and rules at any time, and may not be required to provide you with advance written notice. Such changes may take effect immediately, and can result in a margin maintenance call that you did not expect.
Stay involved in your account
Don't just blindly hand your account over to a stockbroker. If you have unknowingly agreed to margin in your account, you may be trading on margin and taking increased risks. Your account and the investments therein may be highly leveraged, or worse, your investments may be liquidated to repay the debt to the firm.
Always question any suspicious or unauthorized activity in your account
If you notice a negative or debit balance on your monthly account statements, it is likely that margin trading is occurring in your account. Contact your brokerage firm immediately and ask questions. Don't be afraid to ask questions! If you do not want margin trading in your account, instruct the brokerage firm to update your account information.
If you believe you have suffered losses as a result of unauthorized margin trading in your account, contact your state securities regulator or consult an attorney.
[i] Excerpted from a Southwest Securities, Inc. new account application utilized in 2007. Other securities firms have similar default margin agreements incorporated into their new account forms.
[ii] More information regarding FINRA's margin regulations and rules can be found at finra.org/Investors/SmartInvesting/AdvancedInvesting/MarginInformation/.