buying stocks on margin

MarginBrochure
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BUYING STOCKS
ON MARGIN
The Basics
BEFORE YOU INVEST, INVESTIGATETM
Securities Industry Association
MarginBrochure
6/7/01
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SIA thanks the Discount Brokerage and
Investor Education Committees and the public
relations executives from member-firms for
their thoughtful review and contributions to
Buying Stocks On Margin: The Basics. SIA also
thanks the Office of Investor Education of the
Securities and Exchange Commission, and the
National Association of Securities Dealers, Inc.
Lightbulb Press granted permission to use the
explanatory chart on page 4.
Illustration: Giora Carmi
Copyright © 2000, Securities Industry Association
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BUYING STOCKS
ON MARGIN
The Basics
MARGIN ACCOUNTS
Brokerage firms allow you to borrow money from
them to buy securities or to use for other purposes.
Your loan is secured with your investment
portfolio. The specific terms, including interest
rates, vary among firms, but you may be able to
obtain the loan at a rate below what banks charge
for most personal or home equity loans. With
some accounts, you access your margin account by
using a credit card or writing a check. Using
margin loans may make sense as part of your
financial plan. But you need to understand the
potential risks that accompany the benefits.
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HOW MARGIN LOANS WORK
You can buy certain securities on margin, meaning
that you borrow part of the money you need to
pay for stock purchases. The collateral for the
money you borrow may be securities that you
already own, as well as the stock that you are
buying. Because you do not have to put up all the
money, and the stock you buy can appreciate in
value, you have the potential to increase the return
on your investment. But margin loans also
increase your risk. If the price of the stock you
purchase on margin falls sharply, you may lose
more money than you invested. That’s why, in
determining whether a margin loan is suitable, you
need to review your financial objectives and
understand your tolerance for risk.
Investors may also prefer using margin loans for
large emergency expenses, home repairs, and
college expenses because these funds can be
obtained at competitive rates with few, if any,
administrative or processing fees. Once you have
placed securities in your margin account, you can
borrow on margin anytime thereafter, without
having to complete any other applications or
forms. And, unlike other loans, there is no
monthly minimum payment. But again, you need
to weigh the benefits and risks of margin
borrowing within your overall financial plan.
Margin accounts may also be used to fully exercise
any stock options granted by your employer.
To borrow money from your securities firm or
stocks, you must set up a margin account with your
securities firm. The Federal Reserve sets a
minimum initial margin requirement of 50 percent,
meaning that if you buy $10,000 of stock, you must
put at least $5,000 in equity in your brokerage
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KNOW THE MARGIN RULES
The Federal Reserve Board, the New York Stock
Exchange (NYSE), and the National Association
of Securities Dealers (NASD) set margin rules.
Brokerage firms can establish requirements that
are more restrictive, but they cannot be less
restrictive than the Federal Reserve, NYSE, and
NASD.
BEFORE YOU TRADE – MINIMUM
DEPOSIT
Under the NASD and NYSE rules, you must
deposit into your margin account a minimum
of $2,000, or 100 percent of the purchase price,
whichever is less, before you can trade on margin. Firms may, and often do, require you to
deposit more funds than this.
AMOUNT YOU CAN BORROW WHEN
TRADING – INITIAL MARGIN
You can borrow up to 50 percent of the purchase
price of securities that can be bought on margin.
Some firms may require a higher percentage and
restrict the securities that are eligible.
AMOUNT YOU NEED AFTER YOU
TRADE – MAINTENANCE MARGIN
The equity in your margin account (the value of
the stock in your margin account, minus your
loan) must amount to at least 25 percent of the
total value of the account.
Source: Securities and Exchange Commission
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account, with your broker lending you the rest.
Once the margin purchase is made and the stock is
in your account, the New York Stock Exchange and
the National Association of Securities Dealers have a
lower maintenance margin requirement. They
require that the equity in your margin account (the
value of the stock you purchased on margin, minus
your loan) be at least 25 percent of the total value of
the account. Individual firms, however, can impose
higher requirements.
Since you are borrowing on margin, the firm
charges you interest at a rate based on market
conditions. That rate may fall as the loan
increases. Make sure you understand the interest
charges - how the rate is set and how it may change.
The interest you pay for margin loans used for
investment purposes may be treated as
How It Works
YOU OPEN A
MARGIN ACCOUNT
WITH YOUR BROKER
YOU PURCHASE
1000 SHARES
AT $10 EACH
Stock Value
$10
THE VALUE OF
YOUR INVESTMENT
$5,000
$
$
YOUR BROKER’S
INVESTMENT
$5,000
$
$
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“investment interest expense” and could be
deducted on your income tax against an equal
amount of net investment income. Dividends,
interest, annuities, royalties, and short-term
capital gains may be offset dollar-for-dollar, but
certain limits and restrictions apply. Consult your
tax adviser regarding your particular situation.
Note, too, that you may not be able to buy some
securities on margin. Regulations limit margin
loans to those securities that trade on the major
stock markets. Most brokerages also provide
margin lending on municipal bonds, federal
government bonds, notes, and bills, and both
convertible and corporate bonds. Typically, you
cannot borrow against stocks trading under $4 a
share. Firms may impose additional limits,
particularly on securities with volatile swings in
price. These restrictions safeguard investors from
YOU PROFIT
YOU LOSE
IF STOCK
IF STOCK
PRICE RISES
PRICE DROPS
Stock Value
$15
$
Stock Value
$6.50
$
YOUR
BREAKEVEN
POINT
$10,000
$
$
$
$
$
$
$
$
$
MARGIN
CALL
$
$5,000
$5,000
$
$
$1,500
$
$
$2,000
MINIMUM
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shouldering too much risk in their portfolios.
Suppose you buy 1,000 shares at $10 a share (See
chart on previous page). Your cost would be
$10,000 plus any fees or commissions your brokerage firm may levy. By buying on margin, you put
up $5,000 and borrow the remaining $5,000.
If you sell when the stock price rises to $15,
the value of the portfolio has increased to $15,000.
You, however, net $10,000 (minus interest and
commissions) after you repay the $5,000 margin
loan. By borrowing the funds from your broker,
you increased the size of the profit you realized
beyond what you would have gained if only your
own funds had been used.
However, if the price falls to $6.50, the account’s
value stands at $6,500. You borrowed $5,000.
The amount that you borrowed cannot exceed 75
percent of your margin account’s value. So, in this
case, your loan amount is limited to $4,875, $125
below what you have borrowed. You either must
add $125 to the account or sell enough securities
to raise those funds.
A sudden change in the market value of a security
as a result of volatile market conditions may result
in an unexpected margin call. You must either
meet the call — by adding money or securities to
your account to bring it up to the required minimum — or sell the stock, pay back the broker in
full, and take the loss.
Your brokerage firm has the right to sell any securities
from your account — without any notification —
to pay off the loan it made to you. You do not
have the opportunity to choose the securities the
broker sells. That means you could lose the chance
to recoup your losses if the market bounces back.
As a matter of good customer relations, most firms
will try to notify their customers of margin calls,
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but they are not required to do so. You are not
entitled to any extension of time on a margin call.
Above all, you are accountable for any shortfall in
the account after a liquidation resulting from a
margin call.
The financial consequences of a margin call or an
account liquidation may be most severe to customers with small accounts, which are more likely
to be subject to liquidation.
DOES A MARGIN ACCOUNT MAKE SENSE?
Before opening a margin account, you should review
your financial plan and determine your risk tolerance.
Make sure that you fully understand how a margin
account works. Is it appropriate for you? Seek
guidance from your financial adviser. If you plan to
use the margin loan to pay for home improvements or
tuition costs, compare the margin interest rate with the
rates charged for home equity and other types of loans.
REVIEW YOUR ACCOUNT AGREEMENT
If, after understanding the risks and opportunities
of margin accounts, you decide to open an account,
take the time to carefully read the agreement provided by your firm before signing. In doing so, ask:
• What is the interest rate charged for margin
loans? How is it set? Under what circumstances
does it change? How often? How does the
margin rate compare to the rates for home
equity and other types of loans?
• What are the firm’s minimum, initial, and
maintenance margin requirements?
• Which securities cannot be purchased on margin?
• When a firm issues a margin call, what is its
procedure? What steps will it take to notify
you before selling your stocks to comply with
its requirements?
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• Are there any additional charges that you may
incur in opening, maintaining, and closing a
margin account?
• What are the tax implications? Is the interest
you pay on a margin loan deductible from your
federal income tax?
MANAGE YOUR MARGIN ACCOUNT
If you see that the securities in your margin
account are declining in value, you may want to
deposit additional funds in your account. These
cash deposits will reduce your loan and lessen your
chances of a margin call — as long as the value of
the securities in your account do not continue to
decline or you don’t use money to engage in even
more securities transactions.
OTHER CONSIDERATIONS
Securities purchased on margin cannot be registered in your name. They must remain in “the
street name.” Any dividends earned by the margined stocks will be deposited in your account as is
done with shares you wholly own.
CONCLUSION
As with any investment strategy, there are risks and
opportunities with margin accounts. No one buys
stock on margin with the intention of incurring a
loss, but it is well to remember that stock prices
can go down as well as up. Before using margin
loans, carefully consider what is appropriate for
you. Evaluate your financial ability to tolerate
immediate losses if there is a sharp market downturn. Take the time to read the account agreement
before you sign it. And, remember that investing
is a long-term activity for most people.
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The Securities Industry Association brings together
the shared interests of more than 740 securities
firms to accomplish common goals. SIA memberfirms (including investment banks, broker-dealers,
and mutual fund companies) are active in all
U.S. and foreign markets and in all phases of
corporate and public finance. The U.S. securities
industry manages the accounts of approximately
50-million investors directly and tens of millions of
investors indirectly through corporate, thrift, and
pension plans. The industry generates in excess of
$300 billion of revenues yearly in the U.S.
economy and employs approximately 700,000
individuals. (More information about the SIA is
available on its home page: http://www.sia.com.)
Other SIA publications:
• Your Guide to Understanding Investing
• Investor Topics: Basics of Investing
• Best Practices: A Guide for the Securities Industry
• Managing Your Expections for
Long-Term Success in the Stock Market
© September 2000
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BUYING STOCKS
ON MARGIN
The Basics
BEFORE YOU INVEST, INVESTIGATETM
Securities Industry Association
Securities Industry Association
120 Broadway, New York, NY 10271-0080
(212) 608-1500, Fax (212) 608-1604
1401 Eye Street, NW, Washington, DC 20005-2225
(202) 296-9410, Fax (202) 296-9775
[email protected], www.sia.com
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