By Brandon Mantilla
Margin trading, although common practice in the investing community, can make or break your investment portfolio. Many investors, however, do not understand how margin loans work or why they can be so dangerous when not properly utilized or understood. Margin can vastly increase the profit in an account if the leveraged securities increase in value. On the other hand, investors can also lose more money than they put in if the securities perform poorly.
A “margin account” is a type of brokerage account in which the broker-dealer lends the investor cash, using the account as collateral, to purchase securities. There are several inherent risks investors should be aware of before agreeing to trade on margin. Pursuant to margin agreements, it is usual that firms can force the sale of securities in your accounts to meet a margin call. This means that a brokerage firm does not need permission to sell off securities when it determines an account-holder’s equity in the account is too low. Often firms are also not required to contact the investor when securities are being sold, although they often do. Another surprising aspect of margin calls, as these sell-offs are called in the industry, may be that investors do not have a right to choose which securities or assets are sold in the event of a margin call or to receive an extension of time. Lastly, firms reserve the right to change their margin requirements, or minimum amount of equity as a percentage of current market value, on any security, position, or account at any time without advance notice to account holders.
Despite the heavy risk involved in using margin, you can protect yourself from some of these risks by fully understanding the situation you are getting into when you open a margin account. Firstly, you should always make sure you fully understand how margin accounts work by reading about them in materials from reliable sources such as FINRA or the SEC before opening a margin account. Reading the margin rules, FINRA Rule 4210 and Regulation T, as well as your firm’s margin agreement and policies can also go a long way toward preventing any catastrophic consequences that commonly result from a poor understanding of margin trading.
In the event that you do choose to open a margin account, it is critical to actively manage your margin account by regularly reading account statements to understand exactly what is happening in the account. Finally, as any wise advisor might say, you should not put all of your eggs in one basket. In other words, do not put all of your available money in a margin account. Although a financial professional may want to maximize your margin use to raise funds for the firm on interest, keeping safety net funds outside of the account is integral to maintaining your financial well-being.