Margin

Buying on margin allows you to a portion of the purchase price of an investment from your broker. To do so, you must open a margin account with a minimum of $2,000 in cash or negotiable securities, such as stock or bonds, or others that meet your broker's criteria.

When you sell the stock, you repay the margin loan as well as brokers' fees and interest, but keep the remaining profit. This short-term investment strategy can increase your profit substantially more than if you bought the stock outright, but only if the stock price rises higher than the cost of the transaction. Alternatively, because of the loan expenses, if the stock price falls, you risk losing much more than you would otherwise have lost if you had bought the stock outright and sold when then price began dropping.

That's the case because the Financial Industry Regulatory Authority (FINRA), formed through a merger of NASD and NYSE Regulation, requires investors to maintain minimums in their margin accounts to help protect brokerage firms against losses. If the value of your holdings in a margin account falls below a specific level - the FINRA minimum is 25% but most firms set it at 30% or higher - you must add enough cash to bring the value back to the required level. That's known as meeting a margin call. Scottrade's minimum level is 30%.

FINRA Regulation, Inc., issued the following investor guidance to provide some basic facts to investors about the practice of purchasing securities on margin, and to alert investors to the risks involved with trading securities in a margin account.

Use of Margin Accounts

A customer who purchases securities may pay for the securities in full or may borrow part of the purchase price from his or her securities firm. If the customer chooses to borrow funds from a firm, the customer will open a margin account with the firm. The portion of the purchase price that the customer must deposit is called margin and is the customer's initial equity in the account. The loan from the firm is secured by the securities that are purchased by the customer. A customer may also enter into a short sale through a margin account, which involves the customer borrowing stock from a firm in order to sell it, hoping that the price will decline. Customers generally use margin to leverage their investments and increase their purchasing power. At the same time, customers who trade securities on margin incur the potential for higher losses.

Margin Requirements

The terms on which firms can extend credit for securities transactions are governed by federal regulation and by the rules of FINRA and the securities exchanges. This investor guidance focuses on the requirements for marginable equity securities, which includes most stocks. Some securities cannot be purchased on margin. This means Scottrade cannot or will not loan against this security. However, if you hold other securities that meet margin criteria, you may purchase those "non-marginable" securities with the loan value created from the "marginable" securities. For example, certificates of deposit (CDs) are not marginable. However, you may purchase a CD using loan value from other marginable securities.

In general, under Federal Reserve Board Regulation T, firms can lend a customer up to 50% of the total purchase price of a stock for new, or initial, purchases.

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% 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% 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.

Margin Transaction Example

For example, if a customer buys $100,000 of securities on Day 1, Regulation T would require the customer to deposit margin of 50% or $50,000 in payment for the securities. As a result, the customer's equity in the margin account is $50,000, and the customer has received a margin loan of $50,000 from the firm.

Assume that on Day 2 the market value of the securities falls to $60,000. Under this scenario, the customer's margin loan from the firm would remain at $50,000, and the customer's account equity would fall to $10,000 ($60,000 market value less $50,000 loan amount). However, the minimum maintenance margin requirement for the account is 25%, meaning that the customer's equity must not fall below $15,000 (25% of the $60,000 market value). Because the required equity is $15,000, the customer would receive a maintenance margin call for $5,000 ($15,000 less existing equity of $10,000). If the customer fails to deposit the necessary funds, the brokerage firm will automatically liquidate securities in the account to meet the maintenance call requirements.

Firm Practices

Firms have the right to set their own margin requirements - often called "house" requirements - as long as they are higher than the margin requirements under Regulation T or the rules of the FINRA and the exchanges. See Marginable Equity for Scottrade's requirements.

Margin Agreements and Disclosures

If a customer trades stocks in a margin account, the customer needs to carefully review the margin agreement provided by his or her firm. A firm charges interest for the money it lends its customers to purchase securities on margin, and a customer needs to understand the additional charges that he or she may incur by opening a margin account. Under the federal securities laws, a firm that loans money to a customer to finance securities transactions is required to provide the customer with written disclosure of the terms of the loan, such as the rate of interest and the method for computing interest. The firm must also provide the customer with periodic disclosures informing the customer of transactions in the account and the interest charges to the customer.

Visit Margin: Borrowing Money to Pay for Stocks on the Securities & Exchange Commission's Web site for additional investor education about margin borrowing.

Margin trading involves interest charges and risks, including the potential to lose more than deposited or the need to deposit additional collateral in a falling market. Scottrade's margin agreement, available at scottrade.com or through a Scottrade branch office, contains the Margin Disclosure Statement and information on our lending policies, interest charges and the risks associated with margin accounts.