Margin Trading and Excessive Leverage
Purchasing securities using borrowed funds, known as “buying on margin,” can greatly increase the amount of risk that an investor is exposed to. Investors who buy securities on margin or take cash out of their margin account are obligated to pay interest on any balance owed to the brokerage firm. Margin loans are highly profitable for brokerage firms and their stockbrokers who may receive a fee based on the amount of their customer’s margin loan. Many brokerage firms give their customers credit or debit cards linked to their margin accounts so that they can easily tap into their margin account.
Most investors underestimate the amount of leverage or risk associated with using margin. The securities held in a margin account serve as collateral for the margin loan. If the value of the securities that the customer purchased on margin decline in value, the customer can receive a margin call requiring them to deposit more money into the account. The brokerage firm may even sell the securities in the account without notice, possibly at a substantial loss to the customer. In some cases, the customer could end up owing money to the firm.
Because margin trading is so risky, it is only appropriate for sophisticated investors who fully understand the risks and have the financial ability to meet any potential margin calls--sometimes on short notice. For many investors, trading or borrowing on margin is far too risky and unsuitable. A stockbroker who encourages the use of margin in such situations may be in violation of industry rules and liable for any ensuing financial harm.