For many investors who prefer greater liquidity, coronavirus-induced market turbulence threatens to rack up losses, expenses, and fees. This is especially true when compounded by complex investment strategies improperly marketed and sold to unsophisticated and risk-averse investors.
Margin trading is one such investment strategy generally regarded as unsuitable for conservative-to-moderate risk customers. Whereas use of margin often is not exposed as a problem during boom times, just like fraudulent schemes during high tide, the market's success serves to hide the risk of buying on margin...that is, until the market tumbles as it has during the current COVID-19 quarantine.
When an investor buys on margin, that person buys an asset using leverage or borrows money to purchase a securities product. Margin essentially functions like a credit card in that a cash payment isn't required upfront, except that unlike a credit card, an investor who routinely buys on margin often will plan on repaying the borrower using investment proceeds earned as a result of using the borrowed funds.
The definition of leverage in this context is, "to use borrowed capital for an investment, expecting the profits made to be greater than the interest payable."
This works perfectly for margin investors when the market performs well, as profits exceed the borrowed capital and the client walks away with extra funds, even after repaying the borrower.
When the market falls, however, as it has during the current global health pandemic, margin trading proves problematic for investors who have purchased products at relatively high prices using money or other assets they don't actually have, thus exposing risk-averse investors to losses, fees, and charges they should never have experienced had their broker or adviser properly recommended against unsuitable margin trading.
In 2018, FINRA went as far as to include the use of margin in its priorities letter, writing that representatives had increasingly and unsuitably solicited customers to engage in share purchases on margin without adequately disclosing or portraying the risks involved.
Similarly, leveraged products, such as leveraged exchange-traded funds (ETFs) can amplify losses when the product's underlying index falls. For example, when the underlying index grows from 10 points to 15 points over a certain period of time, a "3x Leveraged" product might increase from 30 (10x3) to 45 (15x3)—which, like margin, is great news when the market is strong.
However, when times get tough and that same index falls, a leveraged product experiences a decrease several times greater than the underlying index. In our scenario, a five-point decrease from 15 to 10 in the underlying index would correspond to a 15-point fall from 45 to 30 in the 3x leveraged product. Unless one came into the investment on the ground floor, the fall is disproportionately severe.
For instance, FINRA in October 2019 fined Newbridge Securities $225,000 for failing to supervise complex securities transactions, including the sale of leveraged ETFs and other non-traditional exchange-traded products.
Complex leveraged products as a high-risk high-reward strategy are generally unsuitable for low-risk investors and a broker or financial adviser who recommends such an unsuitable product to a conservative or moderate investor may be liable for damages incurred as a result of this unsuitable recommendation.
If you have invested with a broker or financial adviser who recommended you purchase stocks or other securities on margin or improperly solicited investments in complex products such as leveraged ETFs, and these unsuitable recommendations have proven harmful to your investments or interests, please call an experienced FINRA arbitration attorney at The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for an investigation and consultation.