Margin transactions are conducted in a special type of account called a margin account. Because of the higher degree of risk involved, there are regulatory restrictions placed on margin accounts. Additionally, they are more closely supervised than standard brokerage accounts.
Read on to find some helpful explanations and insights that will help you decide if a margin account is appropriate for your investing needs.
- What Is a Margin Account?
- What Is the Difference Between a Cash Account and a Margin Account?
- What Does It Mean To Buy on Margin?
- How Much Can You Borrow From a Margin Account?
- Advantages of Margin Accounts
- Disadvantages of Margin Accounts
- Should I Buy on Margin?
When investors open a brokerage account, they are generally offered the option of having a cash or a margin account. In a cash account, all trades must be settled in cash on the settlement date, which occurs two days after the trade date for most securities. A margin account, however, is quite different. If you choose a margin account, you have the option of paying for your trades in cash or using margin, which means borrowing money from your broker at interest to pay for trades.
Due to the use of leverage, margin accounts involve more risk than cash accounts. Not every investor qualifies for a margin account. Brokers will deny margin privileges to clients who lack financial sophistication and sufficient net worth.
Margin accounts allow investors to borrow money from their broker using the securities in their accounts as collateral. They can buy stocks and bonds with borrowed money, or they can withdraw the loan proceeds in cash. Borrowing is not allowed in a cash account.
Clients who have margin accounts may “sell short,” which means that they can borrow a stock rather than money from a broker and sell it — even though they don’t technically own it. Short selling is done when an investor believes a stock will go down instead of up.
To “buy on margin” means that you are buying a security, such as a stock, bond or mutual fund, with money borrowed from your broker to fund a portion of the purchase price.
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The Federal Reserve Board regulates the percentage that investors are allowed to borrow against stocks and bonds. Currently, they allow approved margin investors to borrow up to 50% of the value of marginal securities.
For example, if you had $10,000 worth of XYZ stock in a margin account, you could borrow up to $5,000 from your broker, who would use your XYZ as collateral.
Investors often ask, “Can I withdraw money from a margin account?” The answer is yes. You can take money out of a margin account, but you must maintain the regulatory level of collateral.
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As noted above, margin accounts carry additional risk, but they also offer advantages. Here are the most notable benefits of margin accounts:
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.
With a margin loan, you are investing with other people’s money. Your own personal capital expenses are reduced by as much as half.
You can use a margin account to sell shares of stock short 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. It’s buying low and selling high; only you’re selling first.
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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:
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.
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.
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 still represent a hurdle to overcome. 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.
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The decision on whether to buy on margin is an individual one. Margin can magnify both losses and profits. Do your homework and understand the risks and benefits before you open a margin account. If your finances are sound and you are well-informed, buying on margin can significantly boost your portfolio.
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This article has been updated with additional reporting since its original publication.