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Margin Accounts - What are they and what are the risks?

Many brokerage accounts permit the account holders to trade “on margin.” Frequently however, account holders do not have an understanding of what it means to leverage their assets to make additional investments in such an account. This sometimes leads to losses which can exceed the amount of the initial investment and serious reductions in the net worth of the investor.

In its most basic form a margin account allows an investor to take out a loan using the assets deposited in the account as security for the loan. For example under the Federal Reserve Board regulations an investor can borrow up to 50 percent of his or her initial investment to purchase additional securities. For instance an investor could use $50 dollars deposited in the account to purchase up to $100.00 in stocks. After the initial investment an investor must maintain equity in the account of at least 25 percent of the account.

Here’s an example of how the margin requirements work. Assume that the investor purchases $16,000 worth of securities by borrowing $8,000 from the firm and paying $8,000 in cash or securities. If the market value of the securities drops to $12,000, the equity in the account will fall to $4,000 ($12,000 – $8,000 = $4,000). If the investment firm has a 25 percent maintenance requirement, the account must have $3,000 in equity (25 percent of $12,000 = $3,000). In this case, the investor has enough equity because the $4,000 in equity in the account is greater than the $3,000 maintenance requirement.

Unfortunately many investors begin to get into trouble when the value of the purchased securities begins to fall. Using the example above, if the equities purchased in the account were to fall to $8000.00 in value there would be a serious problem because the equity in the account would have been reduced to zero and there would still be a loan owed of $8000.00. Under that scenario the investment would be a complete loss and the investor would end up owing more money than they had deposited with the investment firm because of interest on the loan and the charges that would have been incurred. Moreover, the investor would have lost all of his initial investment and his assets would have been the subject of a “margin call” or forced sale of the assets without his or her permission or input.

In short, the use of a margin account should only be limited to the very sophisticated investor that has a working knowledge of his or her investments. Under normal circumstances an investor should not be encouraged to invest on margin unless that investor has a specific knowledge and intimate understanding of what is being purchased in his or her account.

For additional information you should see the FINRA Investor Alert that has been issued on the topic of margin investing. You can follow the link here.

If you have lost money using a margin account the attorneys at Penzien & McBride, PLLC have extensive experience in helping investors recover their investments when they have been the victim of improper investment advise or frauds. Contact one of our attorneys by telephone at (586) 690-4400 or visit our contact page.

Penzien & McBride, PLLC is a Michigan law firm serving Michigan businesses and individuals primarily in Macomb, St. Clair and Oakland Counties, near Detroit.