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Investing On Margin–Will Your Chickens Come Home to Roost?

While we sometimes hear our politicians scream about someone’s “chickens coming home to roost,” the origin really deals with curses and offensive words and actions that may come back to haunt you.  The old adage suggests your curses and offensive conduct are like young chickens, and will eventually come home to roost–meaning your bad conduct will eventually rebound to cause you harm.   Perhaps investing on margin in a bull market is an apt analogy.

Indeed, all of our accounts should be showing substantial gains in the last 12 months, as the Trump bull market continues to run.  Compared to numbers one year ago, margin investing is on the rise, with more and more accounts showing increasing margin debit balances. At the end of November 2017, FINRA reported there was more than $627 Billion in margin debit balances in retail customer accounts, compared to $553 Billion at the beginning of 2017, more than a 13% increase in borrowing to invest in stocks.  So is this a curse that may rebound to cause you harm?  Maybe…maybe not.

Purchasing on margin carries with it significant risks, particularly in the event of a rapid market decline.  Margin can, for the right situation and the experienced and sophisticated investor be a very good tool to increase returns on certain investments, particularly short term investments, but at the same time, margin can decimate an account in a declining market or when a particular investment’s value declines.   When the stocks in the account decline, or even if the firm believes the overall market conditions are not favorable to margin investing, the account holder may face a margin call.  The rules of FINRA and the exchanges supplement the requirements of Regulation T by placing “maintenance” margin requirements on customer accounts. Under the rules of FINRA and the exchanges, as a general matter, the customer’s equity in the account must not fall below 25 percent of the current market value of the securities in the account. Otherwise, the customer may be required to deposit more funds or securities in order to maintain the equity at the 25 percent level. The failure to do so may cause the firm to force the sale of—or liquidate—the securities in the customer’s account in order to bring the account’s equity back up to the required level. If the account holder does not have sufficient assets, they must either make a deposit of additional funds or securities, or their assets in that account, and possibly other accounts, will be sold so that the firm is not at any risk.  Make no mistake about it, most margin account agreements permit the firm to sell out your investments at any time, without any prior notice to you or consent from you.  Even if your broker promises you that he will call you first, such promises may not be enforceable.  In the event of an acute dip in the market, your account may be sold out at the short term bottom without any prior notice.

Because of the risk, and the complexity of investing on margin, inexperienced investors and investors that can’t afford to meet any potential margin calls should avoid the temptation altogether.  As one of my senior traders used to say, with margin investing, it is the “quick and the empty handed.”  Given today’s markets, I suggest that it is difficult for most retail investors to be quicker than the market.

If your investment accounts are invested on margin, ask your broker what your exposure may be in a rapidly declining market, and what might be the size of your margin call.  If you can’t cover the margin now, you probably can’t cover the margin when all of your holdings have declined, and such predicament can cost you a lot of money.

As stated by FINRA, before you decide to open a margin account, make sure you understand the following risks:

  • Your firm can force the sale of securities in your accounts to meet a margin call.
  • Your firm can sell your securities without contacting you.
  • You are not entitled to choose which securities or other assets in your accounts are sold.
  • Your firm can increase its margin requirements at any time and is not required to provide you with advance notice.
  • You are not entitled to an extension of time on a margin call.
  • You can lose more money than you deposit in a margin account.

Most basic retail investors probably shouldn’t invest their savings using margin.  If you have been talked into investing on margin, and you don’t really understand the risks and can’t afford to make additional deposits to meet any future margin calls, your broker may have been recommended margin when you shouldn’t be investing using margin.  Such recommendation would be unsuitable, and any losses from such recommendation should be recoverable.

In the incredible bull market, don’t be greedy.  Invest with your  money, or if you choose to invest using the firm’s money through a margin loan, be extra careful, make sure your brokers explains, and your understand, all of the risks, and be prepared to meet any potential margin calls.   Any investor that has suffered losses because their broker recommended margin when the investor either didn’t understand, or shouldn’t be exposed to the risk of margin investing, is likely entitled to recover the losses sustained from the unsuitable recommendation, including possibly your costs and attorneys’ fees.

So, for the broker recommending an unsuitable margin investment, or for the inexperienced investor that is exposed to more debt than they can afford to repay, be careful—if the market declines your chickens may come home to roost.