UNDERSTANDING MARGIN CALLS
Maybe you're familiar with margin calls from the 2011 movie of the same name starring Kevin Spacey and Jeremy Irons. If not, here's how Investopedia defines it: "A broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when your account value depresses to a value calculated by the broker's particular formula." Ok, the plain-English version now: "Trading on the margin is borrowing money from your broker to buy stock."
What margin trading allows you to do is to buy or control more stock than you can actually afford at any given moment, provided you have a margin account with your brokerage. Think of it like a mortgage. Margin trading, like mortgages, increase your buying power. You may not have the $250,000 in cash you'd need to buy your house outright, but with a cash deposit of, say, $50,000, you become the "owner" of the house (as long as you continue to make your mortgage payments, that is). Note: by law, your brokerage is required to obtain your signature before opening a margin account, which may be part of your initial paperwork when you signed on with the brokerage or a completely separate agreement. At any rate, what happens now is, the brokerage puts a minimum of $2,000 in a margin account for you (minimums may vary, but the legal minimum is $2,000), and from then on, you can borrow up to 50% of the margin price of any stock.
The Perils of Investing on the Margin
Hopefully the stock you own on the margin goes up. If it does, when the time is right, you can sell the stock you bought on the margin, pay back the money you borrowed from your broker, plus interest, and keep the rest for yourself. But if the stock goes down, well, you've not only lost money through the decline in stock value, you still have pay your broker back, plus interest. In the homeowner analogy we offered above, that's like finding yourself "underwater." Margin calls come into play when your margin trading causes you to dip below your margin minimum. At that point, your broker will demand that you pony up to meet your minimum by transferring money from your cash account, or by depositing additional funds from an outside account.
Now, margin trading, like a lot of nifty things, is great if you use it correctly. The problem is, since you're borrowing money, and the interest is constantly accumulating, margin trading should really only be used as a short-term investment tactic. Again, Investopedia: "The longer you hold an investment, the greater the return that is needed to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you."
Like Other Complex Products or Strategies, Margin Trading Can Be Misused
This is where, if you're not the most sophisticated investor in the world, or you just don't have a strong grasp of how margin trading works, you can get in trouble. It's also where your broker or investment adviser can get in trouble. Chances are, if you've found yourself here on our site to explore margin calls, it's probably not for educational purposes alone--there are plenty of other places for that. No, you probably find yourself here because something related to margin trading went badly wrong. And while there's absolutely nothing inherently illegal or shady about margin trading, as with other sophisticated financial products and arrangements, trading on the margin and margin calls can create big headaches (and losses) if misused.
The most common problem with trading securities on the margin and margin calls is related to unsuitability. As a general rule, unsophisticated investors or investors with low risk-tolerance should not be involved in margin trading and should be encouraged by their brokers to participate in margin trading. Nor should margin trading be used by a broker as a long-term investment tactic, for the reasons described above.
PA & NJ SECURITIES LAWYERS
If you're not sure if you're trading on the margin, ask your broker immediately. And if you or anyone you know has been a victim of broker misconduct related to margin trading, contact us immediately for a free consultation.
