BUYING STOCKS ON MARGIN

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1 BUYING STOCKS ON MARGIN The Basics BEFORE YOU INVEST, INVESTIGATE TM Securities Industry Association

2 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

3 1 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.

4 2 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

5 3 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

6 4 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

7 5 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 IF STOCK PRICE RISES YOU LOSE IF STOCK PRICE DROPS Stock Value 15 10,000 Stock Value 6.50 YOUR BREAK- EVEN POINT 5,000 1,500 5,000 MARGIN CALL 2,000 MINIMUM

8 6 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,

9 7 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?

10 8 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.

11 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: 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

12 800 Nicollet Mall Suite 800 Minneapolis, MN piperjaffray.com Securities Industry Association 120 Broadway, New York, NY (212) , Fax (212) Eye Street, NW, Washington, DC (202) , Fax (202) Securities products and services are offered through U.S. Bancorp Piper Jaffray Inc., member SIPC and NYSE, Inc., a subsidiary of U.S. Bancorp. Not FDIC insured No bank guarantee May lose value

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