If you just found a hot stock but can’t afford to buy as much of it as you want, you have the option of opening a stock margin account. A margin account enables you to borrow money from a brokerage firm to invest in stocks. However, it’s essential to clearly understand how a broker margin works before you start a margin account. While it can potentially amplify your profits, margin trading also exposes you to higher risks when your trades go sour. Below is a comprehensive guide to understanding margin accounts.
- What Is a Margin Account?
- How Does a Margin Account Work?
- What Is the Difference Between a Cash Account and Margin Account?
- Pros and Cons of a Margin Account
What Is a Margin Account?
A margin account refers to an account with a brokerage firm that allows you to borrow cash to buy stocks and other financial products. In order to get a loan from your broker, you’re required to use the stocks you purchase and cash as collateral and make interest payments on a regular basis. Besides paying interest, you also have to meet certain requirements to maintain your account. Since you’ll be investing with borrowed money, using a margin brokerage account can magnify your profits and losses.
How Does a Margin Account Work?
Now that you know the basic margin account definition, you may be wondering, “how does a margin account work?” There are several things you need to know to gain a clear understanding of a margin brokerage account, including:
In general, you’re allowed to borrow up to 50% of the total price of your marginal investments when you sign up for a margin account, meaning you can potentially double the amount of stocks you can afford if you use cash. Not many investors borrow to that extent because of the increased risks involved.
For example, if you have $10,000 in your margin account, you can purchase up to $20,000 worth of marginal stocks. You have to pay 50% of the total purchase price and your broker will lend you the other 50%. In other words, you will have $20,000 worth of buying power.
Usually, you can also borrow against the stocks and bonds that are already in your margin account. For instance, if you have $10,000 worth of marginal stocks that you have yet to borrow against, you can buy another $10,000. The stocks you already own serve as collateral for the $5,000 and the newly bought marginal stocks provide the collateral for the other $5,000. You’ll then have $20,000 worth of stocks in your margin account at a loan value of 50%, without additional cash outlay.
Since margin trading requires you to use the value of your marginal stocks as collateral, the amount you’re allowed to borrow may fluctuate on a daily basis along with the value of your marginal stocks. If your marginal stocks increase in value, your purchasing power increases. Conversely, if they fall in value, so does your buying power.
As mentioned earlier, you have to pay back the amount you borrow plus interest when you purchase stocks on margin. The interest rate may vary from one brokerage firm to another, depending on the amount of money you borrow and the amount of time you need to repay the loan. Nonetheless, it’s typically lower than the rates that apply to unsecured personal loans and credit cards.
When you take up a margin loan, you don’t have to follow a set repayment schedule. Your broker will add monthly interest charges to your account and allow you to pay off your loan at your own convenience. It’s important to note that margin interest charges may be tax deductible when you purchase taxable investments on margin.
Remember, the investments in your margin account serve as collateral for the loan you obtain from your broker. Although the value of your marginal stocks changes according to movements in the stock market, the amount you borrowed remains the same.
To ensure that margin traders will be able to pay back their loans, brokerage firms set minimum equity requirements for margin accounts, which usually range from 30% to 35%. If the value of your investments falls below the minimum equity requirement for your margin loan, you’ll receive a margin call. Also known as a maintenance call, a margin call occurs when your brokerage firm asks you to immediately deposit cash or marginal stocks to bring your equity back to the minimum level.
For example, you already have $10,000 worth of stocks and decide to buy an additional $10,000 on margin. This means you have $20,000 worth of stocks minus $10,000 of margin debt, resulting in a margin equity of 50%. If the value of your stocks fall to $12,000, your equity will be $2,000 since your margin debt will stay at $10,000. If your broker’s minimum equity requirement is 30%, which is $3,600, you’ll receive a margin call. Keeping margin balance versus margin equity in mind is the key to proper margin account management.
What Is the Difference Between a Cash Account and Margin Account?
If you’ve yet to start a trading account, you need to compare a margin account versus cash account to determine which one is more suitable for you or whether you should open both. Investors who want to maximize their potential gains often have both a cash account and margin account. When contemplating trading on margin versus cash trading, your main consideration should be the amount of capital you have. If you have a lot of cash, a margin account may not be necessary.
In a margin versus cash account comparison, the main difference is that a cash account doesn’t allow any borrowing of money from the brokerage firm. A cash account is the safest option, because it prevents you from losing more money than you have. It requires you to use cash to pay for your trades by the required settlement dates. This means you need to have enough cash settled in your account before you can place a buy order. Similarly, you’ll have to wait for funds from a sell order to settle before you can withdraw them.
Another benefit of using a cash account is that you won’t ever receive a margin call. However, unlike a margin account, it doesn’t give you the ability to short sell stocks. With a cash account, you have to deal with options more conservatively. For instance, you must fully cover every call and fully secure every put with cash reserves if an exercise occurs.
If you want to trade with both cash and margin, you should consider opening a cash-margin account. Most brokerage firms allow you to simply add a margin capability to your trading account, so you don’t need to open separate accounts. This will eliminate the need to contemplate, “Should I open a cash or margin account?”
Pros and Cons of a Margin Account
Depending on your trading style and strategy, using a margin account may or may not be a suitable option for you. In order to make a better-informed decision, you should properly weigh the pros and cons of a margin account.
- Increased buying power: This is the most obvious benefit of margin trading. Borrowing money from your broker enables you to control a significantly larger position than you can with your existing equity.
- More flexibility: Besides allowing you to take larger positions, buying on margin also makes it easier for you to diversify your trades. For example, if you have a small trading account that enables you to take only one position at a time, you can use margin to open multiple trades simultaneously. Diversifying your trades can lower your risk because it can help you mitigate your losses if one of your trades go south.
- Greater growth potential: Before the advent of margin trading, smaller traders had a hard time growing their accounts rapidly because they weren’t able to take positions larger than their account balances. With a margin account, you have the opportunity to take on multiple markets, profit from more trades, and grow your account at an exponential rate.
- Higher risk: Controlling a larger position not only increases your profit potential, but it can also lead to bigger losses when things don’t go your way. Therefore, you have to be extremely careful and follow money management and risk mitigation rules very closely when you trade on margin.
- Margin calls: If you fail to resolve a margin call promptly, you may be forced to close your trades at a loss, leaving you with a small portion of your initial equity. In some cases, a margin call can result in a lawsuit or bankruptcy. So, you should try your best to avoid margin calls at all times.
With margin accounts explained, you’re now in a better position to decide whether you should open a margin account. While it exposes you to greater risk, margin trading can be a powerful tool for increasing your trading profits if implemented properly. If you want to learn more about margin trading or other aspects of stock trading, consider signing up for our free, seven-day RagingBull Bootcamp to learn proven tips and tricks from our accomplished trading experts.