Financial Tip of the Month
For the month of December 2003

Buying stock on margin? Proceed with extreme caution

In recent months, investors have been buying stocks on margin at alarming rates. Buying on margin is extremely risky, and too often investors do not fully understand the risks they're taking. Let's look at how it works, what the risks are, and how to deal with them.

How it works

When you buy stock or other securities on margin, you are essentially taking a loan from your broker. Typically you will be required to put up 50% or more of the purchase price, called your "initial margin." The broker will lend you the other 50%.

If the value of your securities goes down, that loss comes from your 50% share, not the broker's loan. However, your share in the account must always equal at least 25% of the current value. This is called your "maintenance margin." If you fall below that, your broker will issue a "margin call" telling you to bring your share back up to 25%. If you don't have cash or other securities to meet that call, your broker can sell securities in your margin account or other accounts to raise the money.

The 50% and 25% numbers shown here are minimums. Your broker may set higher values depending on the securities and market performance.

Example

Assume you buy $80,000 of stock in a 50% margin account. You put up $40,000 in cash, and the broker makes a margin loan for the other $40,000. A week later the company announces bad news and your stock value falls to $44,000. The $36,000 fall in value comes from your share of the account. The broker's loan stays at $40,000 and your "equity" in the account is $4,000.

But the account has a 25% maintenance margin. Your required share in the account is $11,000 (25% of the $44,000 value). The broker issues a margin call for $7,000, the difference between your required $11,000 share and your actual $4,000 share. Unless you can put $7,000 in cash or other securities into the account, the broker will sell some shares in your account to meet the margin call. If you can't meet a margin call, four times the amount of the call (or $28,000) will be liquidated to bring the account into compliance.

The risks

• You lose control over your securities. Your broker can sell securities in your margin account without notice to meet a margin call.
    
• You may need to put up more cash or sell securities in your other accounts if you fail to meet a margin call. Your broker can even sell other securities without your consent.
    
• Your broker can change the margin requirements at any time.
    
• You can lose more than the amount you initially pay in your margin account.
    
• If you are forced to sell securities to meet a margin call, it will likely be when the market is down and prices are low.
    
• Margin accounts are not free. You'll pay interest on the broker's share of the margin account.

If you decide to go ahead

• Do your homework. Understand how a margin account works. Read your broker's rules so you know exactly what they can and cannot do. Know what fees you'll pay.
    
• Keep financial reserves. Make sure you have cash or other securities available to meet a margin call.
    
• Quantify your risks. Run some numerical examples assuming your securities lose 10%, 50%, or 100% of their value.

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