Margin accounts allow investors to buy investments with the help of borrowed money. These accounts employ leverage, which offers both advantages and disadvantages. As margin accounts involve higher risk, they also carry additional restrictions, in terms of maintenance requirements.
Take a look at these investment insights to see if a margin account might be appropriate for your needs.
What Is a Margin Account?
When you open a brokerage account, you can open a cash account or a margin account. In a cash account, you must pay in full for all of your trades. With a margin account, you pay for only a portion of the trade, and you borrow money from your brokerage firm to cover the rest.
Margin Account Basics
Typically, investors can borrow up to 50 percent of the purchase price of a stock when they first open a margin account. For example, if you want to buy 1,000 shares of a $20 stock, you’d only have to put up $10,000 of the total $20,000 cost. You’d borrow the remainder from your brokerage firm, paying interest on that balance.
In addition to your initial margin, most firms require you to meet a maintenance margin requirement of at least 30 percent. If the value of your stocks that provide collateral declines, you might get a margin call that requires you to put up additional money to meet that requirement.
Advantages of Margin Accounts
Margin accounts might carry additional risk, but they also offer advantages. Here are the most notable benefits of margin accounts:
When stock prices rise, stocks bought on margin can magnify those gains. When you add margin, your buying power increases so that you can buy more shares. If the stock later rises, you could potentially make a higher profit than you would without margin.
Reduced Capital Expense
With a margin loan, you can buy more shares for less of your own capital. At a 50 percent margin, you’d only have to put up half of the purchase price of the stock you buy.
Profits in Falling Markets
You can use a margin account if you want to sell shares short. When you engage in directional short selling, you sell borrowed stock, according to Charles Schwab & Co. Once you borrow the stock, you can then generate a profit in a falling market by buying those shares back at a lower price than your sale price and pocketing the difference.
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Disadvantages of Margin Accounts
Knowing the cons of margin accounts can help you decide whether you need one. Here are the drawbacks to margin accounts:
Leverage works both ways. If you trade on margin and the stock later falls, you could end up with a larger loss than you would have incurred from trading without margin.
Falling stocks in a margin account are a double whammy. Not only must you endure the actual loss, which can be magnified due to the effects of leverage, but you might also be forced to put up additional money or marginable securities if you get a margin call.
Margin interest rates are typically below the exorbitant rates on credit cards, but they’re still a large hurdle to overcome. If you’re paying 8 percent on your margin loan, for example, you’ll have to make that amount up on your portfolio just to break even.
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