Margin investing offers the opportunity to super-charge investments, but it also holds quite a bit of risk. Recent market volatility has shed a light on some of these risks, particularly for users of app-based platforms like Robinhood.
Let’s consider an example of margin investing with Robinhood. An investor deposits $5,000 cash into a margin account, and Robinhood lends another $5,000 to allow the investor $10,000 worth of securities. The “margin” is the difference between the value of the securities and the loan from Robinhood. This type of investing increases both purchasing power and financial leverage. [1]
If the securities in the margin account increase in value, the investor has the opportunity for a higher profit than they would have had they invested $10,000 of their own.
On the other hand, if the securities decrease in value, the margin investor is at risk of losing more than they would have had they invested $10,000 of their own.
One of the most significant risks of margin investing stems from margin calls. Because securities purchased on margin are used as collateral against the loan Robinhood extends, Robinhood sets “margin maintenance requirements” on each margin account. These requirements are minimum portfolio values that must be maintained by the investor, and they help Robinhood protect the money they’ve loaned. [2]
So, if the market is volatile, as it has been recently, and the value of securities in a margin account falls too far, Robinhood will issue a margin call. The investor must then either deposit additional cash into their account to meet the margin maintenance requirement or close out their position(s).
However, per Robinhood’s Margin Account Agreement and Margin Disclosure Statement, when Robinhood issues a margin call, they also have the right to sell the account holder’s securities without notice nor consultation. [3],[4]
The language of the agreement specifically states that Robinhood is authorized to liquidate or sell the securities in a margin account to cover any margin deficiency, and that they are not required to notify the account holder before making such a sale. The agreement also stipulates that Robinhood has the sole authority to choose which securities are sold in order to satisfy a margin call, and that Robinhood’s margin maintenance requirements are subject to increase at any time, with no advanced written notice required. [3],[4]
Based on this agreement, which all Robinhood margin investors are required to sign, Robinhood has quite a bit of power over margin accounts. Understood in context, however, these stipulations are designed not to put the investor at risk, but instead to allow Robinhood to protect the money they’ve loaned to investors via immediate liquidation and/or covering losses by requiring additional cash deposits. [3],[4]
Margin investors should also be aware that Robinhood’s margin account agreement explicitly states that any disputes must be resolved via arbitration, so neither party to the agreement may sue one another in court. If a dispute arises, an arbitration case would be filed with the Financial Industry Regulatory Authority (FINRA) in order to reach a resolution or settlement. [3],[4] FINRA arbitration is designed to create a fair and expedited alternative to a traditional court case, but it’s important to understand the arbitration process before deciding to make the leap into margin investing.
So, depending on your risk tolerance, margin trading may or may not be an investment tool you want to use in your accounts.
In our next post, we’ll be sharing a start-to-finish overview of what you can expect from the FINRA arbitration process, particularly as it pertains to margin investing.
Sources:
[1] https://www.investopedia.com/ask/answers/041315/why-purchasing-stocks-margin-considered-more-risky-traditional-investing.asp
[2] https://robinhood.com/us/en/support/articles/margin-overview/
[3]https://cdn.robinhood.com/assets/robinhood/legal/RHS%20Customer%20Margin%20and%20Short%20Account%20Agreement.pdf
[4]https://cdn.robinhood.com/assets/robinhood/legal/RHS%20Margin%20Disclosure%20Statement.pdf