Margin Account

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Definition: A margin account is an account offered by brokerages that allows investors to borrow money to buy securities. An investor might put down 50% of the value of a purchase 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.

Working on margin and owning a margin account is something all investors and traders must completely understand. It is imperative! Understanding how a margin account works is an absolute prerequisite to signing a margin agreement with your brokerage.

As the definition suggest, buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you’d be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account in which you trade using only the money you deposited into the account. The important thing to understand about margin is that it has consequences. Margin is leverage, which means that both your gains and losses are amplified. Margin is great when your investments are going up in value, but the double-edged sword of leverage really hurts when your portfolio heads south. Because margin exposes you to extra risks it’s not advisable for beginners to use it. Margin can be a useful tool for experienced investors, but until you get to that point, play it safe.

If you are a Grasshopper, working on margin is a way you can potentially kiss some, or all, of your money goodbye when you consider levering up your portfolio. When opening your brokerage account, you have the choice of making it a cash-only account or a margin account. Margin allows you the ability to borrow funds from your broker in exchange for an annual percentage that can range from a few percentage points to perhaps as high as 8% or 9% in today’s environment. The percent you pay for this loan can be negotiated with your broker.

The upside of leveraging your portfolio is that if you’re right, and the stocks within your portfolio move higher, you can earn a much bigger gain than you would have if you’d solely had a cash account. You make money on your cash, plus you make money on the funds you borrowed. The downside, though, is that if the stocks you own move against you, your losses could be magnified. You lose money on your cash invested, plus you lose money on the funds you borrowed. Not only did you lose the borrowed funds but now you have to pay the borrowed funds back to your broker. Your broker may also require additional funds if your account equity dips too low while using margin. This is called a Margin Call or Maintenance Call. If you don’t have more funds available to deposit into your account, your broker can sell stock in your portfolio at its discretion to meet the equity level required to maintain the remainder of your margin position.

Let’s take a look at a few examples to see how working on margin will affect your account when an investment goes up or down. Investors can borrow up to 50% of the value of the margin-able stock, however few investors borrow to that extreme, the more you borrow, the more risk you take on, but using the 50% figure as an example makes it easier to see how margin works. For our example we will set the margin interest at 8%.

The benefits of margin

Margin can magnify your profits as well as your losses. Here’s a hypothetical example that demonstrates the upside; for simplicity, we’ll ignore trading fees and taxes which I do throughout the site with my trades.

Assume you spend $5,000 cash to buy 100 shares of a $50 stock. A year passes, and that stock rises to $70. Your shares are now worth $7,000. You sell and realize a profit of $2,000.

A gain without margin

You pay cash for 100 shares of a $50 stock -$5,000
Stock rises to $70 and you sell 100 shares $7,000
Your gain $2,000

What happens when you add margin into the mix? This time you use your buying power of $10,000 to buy 200 shares of that $50 stock. You use your $5,000 in cash and borrow the other $5,000 on margin from your brokerage firm.
A year later, when the stock hits $70, your shares are worth $14,000. You sell and pay back $5,000 plus $400 interest which leaves you with $8,600. Of that, $3,600 is profit.

A gain with margin

You pay cash for 100 shares of a $50 stock -$5,000
You buy another 100 shares on margin -$0
Stock rises to $70 and you sell 200 shares $14,000
Repay margin loan -$5,000
Pay margin interest -$400
Your gain $3,600

So, in the first case you profited $2,000 on an investment of $5,000 for a gain of 40%. In the second case, using margin, you profited $3,600 on that same $5,000 out of pocket, for a gain of 72%.

The risks of margin

Margin can be profitable when your stocks are going up. However, the magnifying effect works the other way as well.
Jumping back into our example, what if you use your $5,000 cash to buy 100 shares of a $50 stock, and it goes down to $30 a year later? Your shares are now worth $3,000, and you’ve lost $2,000.

A loss without margin

You pay cash for 100 shares of a $50 stock -$5,000
Stock falls to $30 and you sell 100 shares $3,000
Your loss -$2,000

But what if you had borrowed an additional $5,000 on margin and purchased 200 shares of that $50 stock for $10,000? A year later when it hit $30, your shares would be worth $6,000.

A loss with margin
You pay cash for 100 shares of a $50 stock -$5,000
You buy another 100 shares on margin -$0
Stock falls to $30 and you sell 200 shares -$6,000
Repay margin loan -$5,000
Pay margin interest -$400
Your loss -$4,400

However, if you sell your shares for $6,000, you still have to pay back the $5,000 loan along with $400 interest, which leaves you with only $600 of your original $5,000—a total loss of $4,400. As you can see, when taken to the limit, trading on margin makes it possible to lose your initial investment and still owe the money you borrowed plus interest.

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