Margin Calls

Margin is essentially a loan made by a brokerage firm to its customers. Margin allows investors to borrow money from their stockbroker to purchase more stock using the investments in the account as collateral. While margin may allow investors to magnify the size of their position, it also magnifies the risks, costs, and potential losses.

When margin is used, it increases the required rate of return needed to breakeven on an investment because of the added costs associated with the loan. The higher rate of return required to breakeven might require an investor to change from a more conservative investment strategy to a riskier one to compensate for the higher costs. The risks associated with the riskier investment strategy many times are not disclosed to investors. The use of margin or other lending products may be considered unsuitable for an investor depending on the investor’s risk profile.

The Federal Reserve Board, FINRA, and securities exchanges, including the New York Stock Exchange (NYSE), regulate margin trading. Margin is regulated under Regulation T of the federal securities laws and FINRA Rule 4210. For more information on investing with margin see FINRA’s Investor Alert.

Margin accounts are highly speculative and only suitable for sophisticated investors that can assume the substantial risk of loss of invested capital. Before an investor uses margin, their stockbroker should discuss the risks associated with the use of margin. Investors should read the margin agreement and the disclosures associated with the loan carefully prior to using margin.

Financial advisors can help investors reduce the risks of margin trading by implementing risk management strategies in case the market moves down or against the investments purchased on margin. The use of risk management strategies should be discussed prior to engaging in margin investing.

Brokerage firms provide financial incentives to stockbrokers for recommending the use of margin in their clients’ brokerage accounts due to the profitability to the institution with little to no associated risk. Since margin uses the securities in the account as collateral, the risk of default on the loans is very low while still bringing in revenue in the form of interest charges. For these profits, financial incentives are given to financial advisors whose clients’ accounts have margin loans. These incentives include greater commissions because of the increased amount of assets the financial advisor manages and is able to invest.

Although brokerage firms prohibit financial advisors from providing tax advice to customers many financial advisors do state that margin interest is tax deductible when recommending the use of margin. Many stockbrokers use the tax treatment of margin interest as a selling point when recommending the use of margin.

The Silver Law Group can help you determine whether an investment loss is the result of a brokerage firm and their financial advisor’s unsuitable use of margin in an investment account. If an investor suffers losses as a result of margin calls they may be able recover their losses in a FINRA arbitration claim.