A margin account refers to a brokerage account where a broker lends a trader cash to purchase stocks or other financial products. The margin account and the securities held within it serve as collateral for the loan.
It entails a periodic interest rate that the investor must pay to keep the account active. Borrowing money through a margin account amplifies an investor’s purchasing and trading power. This leverage significantly magnifies both potential profits and losses.
Key Takeaways
- Expanded Trading Power: A margin account allows traders to borrow funds from brokers without needing the full value of a trade.
- Diverse Trading Instruments: Traders can use margin accounts to trade stocks, futures, and options, depending on broker-specific approvals.
- Increased Profit and Risk: Margin trading heightens both profit and loss potential.
- Costs-Inclusive: Borrowed funds come with margin fees or interest costs.
How a Margin Account Works
If an investor uses margin funds to buy securities that appreciate beyond the interest cost, they can earn superior returns compared to purely using their own cash. This leverage works both ways; apart from interest costs, any depreciation in the securities could leave the investor with heavier losses.
If a margin account’s equity drops below the maintenance margin level, the brokerage firm will issue a margin call. Within a specified duration—typically three days—the investor must deposit additional cash or sell some stock to offset part of the deficit.
Brokerage firms can require more capital, liquidate the investor’s securities if needed, or take legal action if the investor violates a margin call or holds a negative account balance.
A margin account has potential losses exceeding the funds an investor deposits, making it suitable only for experienced investors familiar with the complex risks.
Margin accounts cannot be used for purchasing stocks in certain accounts like individual retirement accounts or trust and fiduciary accounts, and they require a minimum account value, usually $2,000.
Margin on Other Financial Products
Besides stocks, other financial products like futures and options can also be purchased on margin. The initial and maintenance margin for these products vary by broker and regulation. Futures typically require much lower margin requirements than stocks.
Real-World Example: Margin Account
Assume an investor has $2,500 in a margin account and buys stock at $5 per share. By borrowing another $2,500 from the broker, the investor can purchase $5,000 worth of stock, or 1,000 shares.
If the stock rises to $10 per share, selling it results in $10,000. After repaying the $2,500 loan, the investor earns $5,000, doubling what they would have made using only their own cash.
Conversely, if the stock drops to $2.50 per share, the investor’s funds are wiped out. A decline to $2.50 per share equals $2,500, causing the broker to issue a margin call for more funds. Failing to comply leads to losing the entire initial investment.
Also consider interest costs: if trading for a year at a 10% interest rate, that’s $250 on the borrowed $2,500. The profit would decrease to $4,750, and any losses increase by $250 plus other fees.
Can You Lose All of Your Money on Margin?
Yes, you can lose more than your initial investment. If you borrow 50% on margin and your stock drops by 50%, you’ve incurred a 100% loss, plus fees, impacting your holding equity even more.
Can Stocks Go to Zero?
Yes, stock values can drop to zero, often seen in bankruptcies. When this happens, the entire investment in that stock is wiped out.
What Are the Disadvantages of Margin?
Disadvantages include magnified losses, the burden of covering loans, commissions, and fees. Interest charges can erode returns, while margin calls need liquidity at short notice, possibly causing forced liquidations and even further losses.
The Bottom Line
Margin trading remains a double-edged sword, regulated yet inherently risky. Only experienced traders who thoroughly understand its complexities, requirements, and potential losses should engage in margin trading.
Related Terms: Leverage, Brokerage account, Margin call, Maintenance margin, Trading.
References
- U.S. Securities and Exchange Commission. “Margin: Borrowing Money to Pay for Stocks”.
- Charles Schwab. “Understanding Futures Margin”.
