What Is a Margin Account?

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A margin account is a brokerage account in which the broker lends the customer cash to purchase stocks or other financial products. Margin is a higher-risk method of using leverage to enhance returns — but it might increase your losses as well. Here’s what you need to know:

How a Margin Account Works

In a cash account, all trades must be settled in cash on the settlement date. This occurs two days after the trade date for most securities.

If you choose a margin account, you have the option of paying for your trades in cash or using margin. This means borrowing money from your broker at interest to pay for trades.

Borrowing money for a trade is known as using “leverage” which is expressed as a ratio. For example; If you trade using 3:1 leverage, you are borrowing $3 for every $1 in your margin account. This means you can potentially earn 3x the returns, but it can also result in 3x the losses.

Initial Margin vs. Maintenance Margin

You can’t just take out a margin loan from your broker. There are requirements you must meet first:

• Initial margin: The amount of an investment purchase you have to pay for with cash. The initial margin is 50% for most investments. That means if you buy $10,000 worth of stock, you’ll have to put up at least $5,000 in cash.
• Maintenance margin: The absolute minimum amount of margin you need to keep in your account. FINRA requires that customer equity never falls below 25% of the value of securities in an account. Most brokerage firms build in a buffer and require clients to keep 30% or 35% maintenance margin at all times.

Margin accounts are regulated by the Securities and Exchange Commission (SEC) and FINRA, detailing deposit requirements, account minimums, and how much you’re able to borrow.

Margin Calls and What Happens When You Fall Below Maintenance Margin

If your trade drops in value too much, you might fall below the required amount of maintenance margin in your account. When this happens, it will trigger a margin call from your broker.

A margin call gives you from a few hours to a few days to add more money to your margin account — or risk your broker selling your investments to get your account back up to the required levels.

How to Open a Margin Account

To open a margin account, you’ll want to choose a broker that offers one, understand eligibility and compare interest rates and fees.

Choosing a Broker for Margin Trading

It’s important to compare several brokers to find one that offers the trading tools, features and margin trading you desire. You’ll want to compare the minimum deposit requirements for your margin account, interest rates on margin loans and customer service responsiveness.

You’ll also want to review broker fees and costs associated with margin trading. And make sure to understand the margin policies including when the broker institutes a margin call and how to handle maintenance margin to keep your account current.

Benefits of a Margin Account

Margin accounts carry additional risk, but they also offer advantages. Here are the most notable benefits of margin accounts:

Upside Leverage

When stock prices rise, the margin will magnify gains. When you use margin, you increase your buying power so that you can afford to buy more shares than you otherwise would have. If the stock rises, you will make a higher profit when margin is employed.

Reduced Capital Expenses

With a margin loan, you are investing with other people’s money. Your own personal capital expenses are reduced by as much as half.

Profits in Falling Markets

You can use a margin account to short sell and profit during a decline in the markets. This trick is achieved by borrowing shares you don’t currently own and selling them into the market.

If they go down, you buy them back at a lower price, pay back your stock loan and keep the profits.

Risks of Using a Margin Account

It’s important that investors know both the advantages and disadvantages of margin accounts before diving in. Here are some of the drawbacks to margin accounts:

Additional Risk

Leverage works both ways. If you trade on margin and a stock goes in an undesirable direction, you could end up with a larger loss than you would have incurred if you hadn’t used margin.

Margin Calls

When you buy on margin, you put up stocks you already own as security against the loan. If the stock you buy moves against you, your broker will sell the collateral stock to protect the firm’s capital.

Known as a “margin call,” it can feel like a double whammy. Not only must you endure your investment loss, but you will also lose shares of the original stock you used as security.

Interest Charges

Like any other loan, you pay interest when you borrow money on margin. Margin interest rates are typically below the exorbitant rates charged on credit cards, but they’re still a cost to consider.

If you’re paying 8% on your margin loan, for example, you’ll have to make that amount up before you can make a profit.

Margin Account Example

For example; say you want to buy $10,000 worth of stock at $100 per share. If you deposit $2,000 and borrow the remaining $8,000, you’re investing with 5:1 leverage. Now you can buy 100 shares of that $100 stock. A year later, when the stock price reaches $150, your shares are worth $15,000, and you decide to sell the stock.

If You Sell At a Gain

First, you have to pay back the $8,000, and then you have to pay the interest. If the interest rate is 8%, then that’s another $640 you will have to pay, leaving you with $6,360. Your profit on the trade ends up being $4,360, much higher than if you just invested your $2,000 cash.

If You Sell At a Loss

If the $100 stock you bought falls to $40 after a year, your loss would have been $1,200 without buying on margin — $800 ending value minus $8,000 initial investment. But if you borrowed $8,000 to buy 100 shares, you would have lost $6,640 — $4,000 ending value minus $2,000 initial investment, minus $8,000 margin loan, minus $640 interest. This is a massive loss and far more than your cash balance.

The Bottom Line

Trading on margin is an advanced investment technique. If you have the money to pay for the initial margin, and you understand all the rules of the SEC, FINRA and your broker, give it a try with smaller investments.

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