What is Margin Trading?
There are two margin definitions. Securities margin is borrowing money to buy stock. However, commodities margin Loan involves putting in your own cash as collateral for the contract.
How Margin Calls Work in Volatile Times
Many margin loan investors are familiar with “routine” margin calls, where the broker asks for additional funds when the equity in the customer’s account falls below certain required levels. Generally, the broker allows two to five days to meet the call. Broker calls are typically based on the account’s near-market value because various securities regulations require end-of-day valuations of customer accounts. The current “close” for most brokers is 4 p.m., Eastern Time.
However, in volatile markets, a broker may calculate account value at the close and continue to calculate calls on a real-time basis in subsequent days. When this happens, the investor may experience the following:
First Day Close: Customer has 1,000 shares of XYZ in his account. The closing price is $60, so the market value of the account is $60,000. If the broker’s equity requirement is 25 percent, the customer must maintain $15,000 in equity in the account. If the customer had a margin loan outstanding against $50,000 of securities, his equity would be $10,000 ($60,000 – $50,000 = $10,000). The broker determines that the customer should receive a margin loancall for $5,000 ($15,000 – $10,000 = $5,000).
Day Two: At some point early in the day the broker contacts the customer (eg, via an e-mail message) telling the customer that he has “x” days to deposit $5,000 into the account. Shortly thereafter, the next day, the broker sells without notifying the customer.
What happened here?
In many cases, brokers have computer-generated programs that will issue an alarm (and/or take automatic action) in the event that the equity in a customer’s account falls further. For example, suppose the value of XYZ stock in the customer’s account continues to drop another $6,000 during the next morning, meaning that the stock is now only worth $54,000.
The customer still owes the broker a $50,000 loan, but now the broker has only $54,000 in market value to secure that loan. So, based on the subsequent decline, the broker decided to sell XYZ’s stock before it fell further.
If the value of the securities had been around $60,000, the broker would have allowed the customer a stated number of days to meet the margin loan call. It was only because the market continued to decline that the broker exercised his right to take further action and sell the account.
What could the customer have done to avoid this?
The bottom line is that margin loan accounts need to work on behalf of the customer. Information about share price is available from any number of sources. In fact, many investors check these prices on a daily basis, if not several times a day. An investor is free to deposit additional cash into the margin account at any time in an attempt to avoid a margin call.
However, even if additional deposits are made, subsequent declines in the market value of the securities in the account may result in additional margin loan calls. If an investor does not have access to the funds to meet a margin call, he probably should not use a margin account. While cash accounts do not provide the leverage that a margin loan account offers, cash accounts are easier to maintain because they do not require the vigilance required of a margin account.
In a partial sale, some—but not all—of the securities in the client’s account will be sold.
Mr. Jones has three stocks in his account with a total market value of $90,000: $30,000 in ABC for which he has significant long-term (i.e., capital) gains, $30,000 in DEF for which he has large losses (which can be used at the beginning of the year offset gain in shares sold), and $30,000 in GHI that has a short-term gain for tax purposes.
Every stock has a maintenance margin requirement of 25 percent. Mr. Jones has a $6,000 unmet maintenance margin loan call, so the broker sells some of his securities. The broker chose to sell GHI. Mr. Jones is in a very high tax bracket, so the sale results in a large tax bill for him. Mr. Jones is upset because he would have preferred to sell one of the other two securities to the broker.
Ms. Young owns $10,000 each in JKL, MNO, and PQR stock. JKL is a fairly stable stock so brokers only require a standard 25 percent maintenance margin loan on it. MNOs are more volatile, so the broker sets a 40 percent “house” requirement on the stock.
Finally, PQR has been experiencing a lot of volatility in recent months, so the broker has set a 75 percent “house” requirement for that stock. Ms. Young has a $2,200 unmet maintenance margin call, so the broker sells some of her securities. The broker chose to sell JKL. Ms. Young is upset because she thinks the broker should have sold shares of PQR because it had the highest (ie, 75 percent) maintenance margin loan requirement.
What happened in the above 2 examples?
It is important to remember that while consumers borrow individually, brokers lend collectively. As such, brokers are concerned with overall financial exposure. In each instance, the broker had numerous customers who borrowed money against GHI and JKL. To reduce its exposure to “concentrated positions,” where one or more securities backed large amounts of consumer debt, the broker’s computers were programmed so that if a sale were required, the securities sold would be those that represented the greatest financial risk. . to the broker.
What could Jones and Young clients have done to avoid this?
The way to avoid this is to realize that the broker is first and foremost an extender of credit who will act to limit his financial exposure to rapidly changing markets. A broker is not a “tax preparer” and is not required to base its actions on the client’s tax situation. Also the broker is not required to sell the securities of the customer’s choice. The only way to avoid a sell-off is to ensure that you maintain an adequate equity “cushion” at all times in a margin account, or limit trades to a cash account, where the investor must pay for trades in full on time.
When $2,000 is not $2,000!
Mr. Smith has read investor education articles that state that the minimum requirement for a margin loan account is $2,000. However, when he tries to open a margin account with Broker S, that broker’s clearing firm will not allow him to trade on margin at all. Mr. Smith then tries to open a margin loan account at Broker T, and is told that he will not open a margin account for him until he deposits $20,000.
What could have happened here?
Brokers, like other lenders, have policies and procedures to protect them selves from market risk, or a decline in the value of security collateral, as well as credit risk, where one or more investors cannot refuse to meet their financial obligations. Broker. Among the options available to them, they have the right to increase their margin loan requirements or choose not to open a margin account.
Margin loan purchases securities on credit while using the same securities as collateral for the loan. Any remaining loan balance is the responsibility of the borrower.
Suppose Mr. Smith recently bought $36,000 worth of stock on margin from broker R. He deposited $18,000 and borrowed the remaining $18,000 from Broker R. Shortly thereafter, the stock’s value plummeted. Broker R sold the stock for $12,000 and kept the proceeds to pay off part of the loan. However, Mr. Since Smith borrowed $18,000, the income of $12,000 did not satisfy the loan. The broker asked Mr. Smith to send a check for the remaining $6,000. Mr. Smith did not pay the $6,000.
When Mr. Smith tried to open accounts at brokers S and T, with each firm conducting its standard credit review process. They each checked the securities industry data center and discovered that Mr. Smith had broker R. Broker A defaulted on a $6,000 loan. He decided that he did not want to do business with Mr. Smith at all, Broker T was only willing. Maintain his account with a substantial deposit.
What can the customer do to avoid this?
Any liability to a broker should be treated as seriously by an investor as any liability to a bank or other lender. Failure to fulfill obligations to the broker may result in legal action against him