Online investors risk accidental debt

Staying Ahead

April 19, 1999|By Jane Bryant Quinn | Jane Bryant Quinn,Washington Post Writers Group

WALL Streeters call it the Crack of Doom. It's the moment when you know, not just that you're going to lose money, but that you're going to lose a lot.

The investors most likely to hear the Cra-a-ack are those buying volatile stocks in margin accounts. They think they know what they're doing, then Doom!

The risk in margin accounts is debt. You borrow from your broker to buy more stock than you have the cash to pay for, and hope that a rising market will make your gamble pay. Maybe it will, but then again, maybe it won't.

Investors who trade their accounts online can blunder into debt unintentionally. For novices, it's an accident waiting to happen.

Margin debt today accounts for more than 2 percent of disposable personal income, says Irwin Kellner, economics professor at Hofstra University, double the previous record, set in 1987.

Margin is wonderful when it works. To see the potential, take a $20 stock that rises to $30. If you bought for cash, you made 50 percent on your money. If you bought on margin -- investing just $10 and borrowing the other $10 from your broker -- you made 100 percent on the money you put up (minus the interest on the loan).

But just as margin enhances your gains, it deepens your losses. Say your $20 stock dropped to $10. Cash buyers lose 50 percent of their money. Margin buyers lose 100 percent.

Brokers charge an adjustable interest rate, higher for smaller loans. At Charles Schwab, it's an annualized 8.75 percent for loans under $10,000, and 8.25 percent for loans up to $25,000. That doesn't count the cost of daily interest compounding. The actual rate you pay is slightly higher than the stated rate, but Schwab and others don't figure it for you.

The Federal Reserve establishes minimum margin requirements. At present, you can borrow up to 50 percent of the value of most stocks.

Online, there are at least three ways you can borrow by accident: You might place an order for a volatile stock -- say, 1,000 shares of an Internet stock, selling for $8 a share. You expect to pay $8,000. But if there's heavy speculation, the price might jump to $15 before your order gets through. Suddenly, you've spent $15,000, and you may not have the extra $7,000 in your account. The trade triggers an automatic loan.

To avoid this risk, use a "limit order." It states the maximum you're willing to pay per share.

You might place an order the night before, see the stock jump when the market opens, and send the broker a quick cancellation. But the cancellation might not go through in time. You're generally stuck with your purchase.

You click the mouse to place an order and the system doesn't respond right away. You click again. Unknowingly, you've doubled your order. If you can't pay for both, the second order will be on loan.

Now comes the painful part: What happens if you borrowed, accidentally or on purpose, and the price of the stock goes down?

You have to maintain the "equity value" of your account at a certain level. In general, your equity value equals the market value of the securities in the account (not counting stocks priced under $5), minus whatever you owe the broker.

Securities regulators require you to maintain at least 25 percent equity in your account. Many brokers set a higher limit -- say, 35 percent or 40 percent equity. They may require 70 percent equity on volatile stocks.

Computers monitor customer accounts throughout the trading day, Jackie Hipps, a senior vice president at Schwab, told my associate, Dori Perrucci. If your stocks drop too far, you get a margin call. That means you have to add cash or securities to your account, and fast. If you don't, your stocks will be sold at a loss.

If the stock is tumbling, it may be sold before you're even notified.

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