A margin account is a brokerage account that allows the customer to use leverage to purchase securities. This means the account holder can take a loan from the broker to make investments. Margin rules are federally regulated, but margin requirements and interest may vary among broker and dealers.
BREAKING DOWN Margin Account
The ability to set up a margin account is offered by most brokers and can give you a lot of buying power without much of any cash investment on trader's part. To understand how margin accounts can be helpful, consider an investor who bought a share of stock for $50 US Dollars (USD), whereupon the market price of the stock went up to $75 USD. If he paid cash for it, the return on his investment is 50%, which is a very respectable rate of return. However, if he paid $25 USD in cash and $25 USD in funds borrowed on margin, his return is 100%. He still has to pay back the money he borrowed, but by spreading his margin borrowing over several purchases, he will increase his profits, as long as the price of his stock goes up.
Margin Account Pros and Cons
A margin account is offered by brokerages that allow investors to borrow money to buy securities. An investor might put down 50% of the purchase price and borrow the rest from the broker. The broker charges the investor interest for the right to borrow money and uses the securities as collateral. However, in volatile markets, a broker may calculate the account value at the close and then continue to calculate calls on subsequent days on a real-time basis. A margin loan can be a valuable tool in the right circumstances, but be aware that it can magnify both profits and losses.
Once the equity of your account drops down and you get under maintenance margin threshold of your broker, they then have the right to issue a “Margin Call”. A margin call says that your broker can either sell your positions without your consent in order to get their investment back, or they may require you to deposit additional capital into your account to get you back above the maintenance margin threshold.
Buying on margin is mainly used for short-term investments because of the interest charges. Margin works well when investments are going up in value but can be crippling if the value goes down. That’s why margin account better suits for sophisticated investors knowledgeable in additional investment risks and demands.
Federal Regulations on Margin Accounts
The Federal Reserve limits the amount which may be borrowed on margin to 50% of the value of the purchase. A margin account is necessary when selling stocks short, and is usually used by people who simply want to leverage their investment, rather than people who can’t afford the full purchase price of the securities.
Besides that, margin account cannot be used for buying stocks on margin for an individual retirement account (IRA), Uniform Gift to Minor account (UGMA), a trust or other fiduciary account; these accounts require cash deposits. In addition, a margin account cannot be used when purchasing less than $2,000 in stock; buying stock in an initial public offering (IPO); buying stock trading at less than $5 per share; or for stocks trading anywhere other than the New York Stock Exchange (NYSE) or the NASDAQ National Market.
Although use of highly leveraged margin may increase the potential for gains, traders should carefully consider the risks and costs of using it before entering their trades.
2022-11-23 • Updated