My client was shocked when I told her how much money she had lost. She responded, "That's impossible! I didn't have that much money to invest. How could I have lost more money than I invested?" My client was unaware that margin was used in her brokerage account.

What is margin and why use it?

Think of margin as a loan from your brokerage firm where the firm uses your existing securities as collateral. The money lent you can be used to buy additional securities or to cover personal expenses. The incentive for some is that margin can satisfy short term cash needs. For example, one investor did not have the cash to make her daughter's college tuition payment, however, she knew that in several months she was going to receive a substantial bonus from work. Rather than disturbing her stock portfolio, she took a margin loan on 10% of her account and paid it off when she got her bonus.

More common is the situation where an investor purchases additional securities on margin. That investor (or the broker) is banking on the investment going up in value. If it does, then the investor stands to make money on an investment he didn't entirely pay for himself. For example, if you bought 200 shares of Corporation X at $10 and paid $1,000 in cash and $1,000 in credit, you would have $2,000 worth of Corporation X. If the price then rose to $20.00 a share, your investment would be worth $4,000, an increase of 300% over your initial layout of $1,000. Hence, the benefits of margin.

Danger ahead

"Margin is a double edged sword," says Douglas J. Schulz, a registered investment advisor in Colorado Springs. "Margin leverages your account so that if you guess right, you increase your profits, but if you guess wrong, you multiply your losses." If your investments take a dive, and the equity in your account falls below 30% of its current market value, your broker will issue a margin call to pay off some of the loan. Margin calls can be satisfied in one of two ways - either you send in additional cash or some of your current holdings are liquidated in order to cover the margin call.

The problem arises when the broker sells something at a loss in order to cover your margin call. Embedded in the various documents that you are required to sign before opening a brokerage account are the margin provisions which may authorize your broker to utilize margin in your account. Also buried in the margin language (among superfluous and difficult to understand words and phrases we lawyers are so want to use) is a sentence that provides that with or without any notice to you, the brokerage firm can immediately liquidate your holdings in order to cover your margin call. Therefore, guessing wrong about the expected performance of your portfolio could lead to disastrous results.

Also, realize that the credit issued from your broker does not come free - you must pay interest. The interest rate on a margin loan, while lower than what you would pay on an unsecured loan, is often higher than what you are earning on the investment. And the brokerage firms borrow the money for less than what they charge you. Margin is a large profit center for brokerage firms. In some years, brokerage firms have made as much in margin as in commissions. This creates a conflict of interest when your broker recommends the use of margin.

Minmize your risk

Your broker is required to discuss the use of margin in your account before using it. Schulz generally cautions his clients against using it. He says that if your broker recommends margin to purchase long term investments, such as municipal bonds or conservative mutual funds or stocks or bonds you intend to hold - DON'T! He maintains that the margin costs will most likely be a negative spread compared to what you are being paid in dividends or interest. Second, if the market turns down, you may be forced out of a position you wanted to keep at the worst possible time - when the price is lower. "The majority of investors who were hurt in the 1987 market crash were those who were forced to sell their investments at severe discounts due to margin calls. The market turned around almost immediately, leaving the margined investors with stinging losses," according to Schulz.

Do not consider using margin unless you have the resources to absorb the losses which could result from a downturn. It is not uncommon for individuals, when asked about their net worth or their liquid assets by a broker, to inflate the figures. Whether it's optimism, egotism, or desperation that spurs such conduct, it can spell danger when dealing with margin. It is critically important for investors to be honest when asked about their financial condition. Brokerage firms typically monitor their customers credit status. They will not permit a customer to carry substantial positions while in a margin call unless the firm believes that the customer has the financial means necessary to satisfy any deficit that might be incurred.

Most brokerage firms provide notice of a margin call to customers as a courtesy. However, if you receive a margin call, absent any written notification of your deadline by which to respond, act fast. Don't assume that the firm will wait for you to come up with the money. They may not, and the language in the Agreement will support their action. In one court case, the court rejected a customer's claim that one hour's notice was inadequate.

Margin's appeal has increased recently with the prolonged bull market. Most of the margin buying this year appears to be in the stock market, including margin buying of stock mutual funds. To many, borrowing to make such purchases is too aggressive and best suited for speculators vying for short term profits. Wise advice regarding any investment activity is, "Proceed with caution" with a keen awareness of both the pros and the cons.