If the price of the stock goes up you get to keep all of the profit when you sell the stock, merely repaying the amount borrowed plus interest and fees. The problem comes when the price of the stock goes down. If you sell the stock at a loss, you keep whatever is left after repaying the loan plus interest. It is possible to lose all of your money and still owe the broker additional funds.
The price of stocks fluctuate which is not normally a problem if you are intending on holding the stock for a while. However, when you buy stock on margin, you need to maintain your margin maintenance requirement. If the price of the stock goes down too much, then you will receive a margin call. This is a demand for you to add more money into your account to protect the amount loaned from the broker. Call it the broker’s safety buffer.
If you do not have additional funds to add to your account, then you’ll have to sell the stock at a loss. If the price of the stock drops dramatically, then the broker might sell the stock without prior notification to you, as there is no requirement that they contact you before selling the stock from under you. Of course this always happens at the point of greatest loss.
Even if you get a margin call, and you are sure that the drop in the price of the stock is only temporary, chances are, you are not going to have the additional funds needed to meet your margin call. If you are lucky, this is the point that you are buying on margin. You are not likely to ever be that lucky.
But who am I for you to take advice from? I am certainly neither a professional nor even a person in ‘the know.’ However, I just came to conclusion that persons buying stock on margin is one reason for some of the illogical movements seen recently in the stock exchange. There is no need to heed my warnings. Instead take a look at the warning from the Security and Exchange Commission, the SEC:
Be sure not to overlook this warning:
Recognize the Risks
Margin accounts can be very risky and they are not suitable for everyone. Before opening a margin account, you should fully understand that:
- You can lose more money than you have invested;
- You may have to deposit additional cash or securities in your account on short notice to cover market losses;
- You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
- Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.
You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines. Know that your firm charges you interest for borrowing money and how that will affect the total return on your investments. Be sure to ask your broker whether it makes sense for you to trade on margin in light of your financial resources, investment objectives, and tolerance for risk.
Understand Margin Calls – You Can Lose Your Money Fast and With No Notice
If your account falls below the firm's maintenance requirement, your firm generally will make a margin call to ask you to deposit more cash or securities into your account. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm's maintenance requirement.
Always remember that your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm's maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.
If this is not warning enough for you, how about taking a look about what the NASD has to say about margin. Just look at the title of the Investor Alert posted about margin:
“Investing with Borrowed Funds: No "Margin" for Error.” - NASD
The Alert mentions a number of issues, including:
No shortage of risks to be sure. However, look who’s not risking anything:
There are a number of risks that you need to consider in deciding to trade securities on margin. These include:
- Your firm can force the sale of securities in your accounts to meet a margin call. If the equity in your account falls below the maintenance margin requirements under the law—or the firm's higher "house" requirements—your firm can sell the securities in your accounts to cover the margin deficiency. You will also be responsible for any short fall in the accounts after such a sale.
- Your firm can sell your securities without contacting you. Some investors mistakenly believe that a firm must contact them first for a margin call to be valid. This is not the case. Most firms will attempt to notify their customers of margin calls, but they are not required to do so. Even if you're contacted and provided with a specific date to meet a margin call, your firm may decide to sell some or all of your securities before that date without any further notice to you. For example, your firm may take this action because the market value of your securities has continued to decline in value.
- You are not entitled to choose which securities or other assets in your accounts are sold. There is no provision in the margin rules that gives you the right to control liquidation decisions. Your firm may decide to sell any of the securities that are collateral for your margin loan to protect its interests.
- Your firm can increase its "house" maintenance requirements at any time and is not required to provide you with advance notice. These changes in firm policy often take effect immediately and may cause a house call. If you don't satisfy this call, your firm may liquidate or sell securities in your accounts.
- You are not entitled to an extension of time on a margin call. While an extension of time to meet a margin call may be available to you under certain conditions, you do not have a right to the extension.
- You can lose more money than you deposit in a margin account. A decline in the value of the securities you purchased on margin may require you to provide additional money to your firm to avoid the forced sale of those securities or other securities in your accounts.
Margin Loans: Who's Profiting?
Margin loans can be highly profitable for your brokerage firm. They may also be highly profitable for your broker. Your broker may receive fees based on the amount of your margin loans. This may take the form of a percentage of the interest you pay on an ongoing basis. - NASD
To receive a margin call a stock only needs to make one trade at a price below your margin requirement. So even if the price of the stock recovers during the day, you may still have to pay into your account. This might explain the sharp drop in a stock’s price when it manages to meet expectations. Brokers might try to trigger as many margin calls as possible, in addition to triggering as many stop-loss orders as possible. A stop-loss order is when the price of the stock goes below a certain level, this then triggers your stop loss order to sell the stock at market.
Buying even good stocks on margin can be risky as sometimes the entire market moves down on disappointing news that is not related at all to the stock itself. Take poor results from a top corporation in the same sector as a stock that you own on margin. This might result in an unplanned margin call for you.
Information concerning trading on margin often caries a warning that margin is for experienced traders only. I consider myself an experienced trader and I know that I do not have the discipline to avoid a margin call and I never have additional funds that I don’t already have a purpose for. If I was trading on margin and received a margin call, I would be forced to sell. Thankfully I have a cash account and while my stomach turns inside out sometimes on red market days, I am often confident enough in what I own to hold for a better day to sell, most times for a profit.
If you buy stock on margin, your broker most likely has the right to loan out your shares to a short-seller. This has two main effects. First, they help to limit any pressure to increase the price of the stock by increasing the supply and essentially allowing your shares to be bought twice, once by you, and then again when the short seller sells them. If this happens to your shares, you might suffer the second effect, you don’t receive any dividend that the stock might payout. You will receive a payment from the short-seller for the amount of the dividend, but that will be taxed at a different rate as the payment was not a dividend. (More on short selling in a future post.)
Note: This post mentions that brokers “might” do some nasty things to manipulate the market. Of course I did not mean you, after all, that would be illegal.
Borrowing Money To Pay for Stocks – US SEC
Investing with Borrowed Funds: No "Margin" for Error - NASD
Dividend Tax Breaks at Risk – Fool.com
Dividends on Stock in Margin Accounts May Not Be Eligible for Reduced Tax Rate – Morgan Keegan
And also Searchlight Crusade.