What is a Margin Account?
The term “margin account” refers to a brokerage account where a trader can borrow money from their broker-dealer to purchase stocks or other financial products. The margin account and the securities within it serve as collateral for this loan.
A margin account comes with a periodic interest rate that the investor must pay to maintain the account. Borrowing money through a margin account allows investors to enhance their purchasing and trading power. Using margin accounts involves leverage, which can magnify both profits and losses for the investor.
Key points:
- A margin account allows a trader to borrow funds from a broker without needing to cover the entire value of a trade upfront.
- Traders can use margin accounts to trade various financial products, including futures and options (if approved and available with the broker), as well as stocks.
- Margin trading increases the potential for both profit and loss on the trader’s capital.
- When trading stocks with borrowed funds, a margin fee or interest is charged on the borrowed amount.
How Margin Account Works
If an investor purchases securities using margin funds and those securities appreciate in value beyond the interest rate charged on the borrowed funds, the investor will achieve a higher total return than if they had only used their own cash. This illustrates the advantage of using margin funds.
On the downside, the brokerage firm charges interest on the margin funds for as long as the loan is outstanding, which increases the investor’s cost of purchasing the securities. If the securities decline in value, the investor will incur losses and still owe interest to the broker.
If the equity in a margin account drops below the maintenance margin level, the brokerage firm will issue a margin call. The investor must deposit more cash or sell some securities to bring the account back to the required level, often within three days, though this period can sometimes be shorter.
A brokerage firm has the right to require an investor to increase the capital in their margin account, sell the investor’s securities if the broker feels their funds are at risk, or take legal action if the investor does not meet a margin call or carries a negative balance.
The investor risks losing more money than the amount deposited in the account. Therefore, a margin account is only suitable for sophisticated investors who thoroughly understand the additional risks and requirements of trading with margin.
Furthermore, a margin account cannot be used for buying stocks on margin in individual retirement accounts, trusts, or other fiduciary accounts. Additionally, a margin account is not available for stock trading accounts with balances less than $2,000.
Margin on Other Financial Products
Financial products other than stocks can be purchased on margin, such as futures, which traders frequently buy using margin.
For various financial products, the initial margin and maintenance margin requirements differ. Exchanges or other regulatory bodies set the minimum margin requirements, but some brokers may impose higher requirements.
This variation means that the margin can differ depending on the broker. The initial margin required for futures is often much lower than for stocks. While stock investors must put up 50 per cent of the value of a trade, futures traders may only need to put up between 3 per cent and 12 per cent.
Margin accounts are also required for most options trading strategies.
Example of a Margin Account
Assume an investor with $2,500 in a margin account wants to buy a stock priced at $5 per share. The investor can use additional margin funds of up to $2,500 supplied by the broker to purchase $5,000 worth of stock, equivalent to 1,000 shares.
If the stock’s value rises to $10 per share, the investor can sell their shares for $10,000. After settling the broker’s fee of $2,500 and deducting the initial investment of $2,500, the investor nets a profit of $5,000.
Without borrowing funds, the investor would have only made $2,500 when the stock doubled. By leveraging their position, the potential profit is doubled.
However, if the stock drops to $2.50 per share, the investor’s entire investment is lost. Since 1,000 shares at $2.50 per share equals $2,500, the broker would issue a margin call, notifying the investor that the position will be closed unless additional capital is added to the account. In this case, the investor loses their initial investment and can no longer maintain the position.
These scenarios assume no fees, but interest is charged on borrowed funds. If the trade took one year and the interest rate was 10 per cent, the investor would pay 10 per cent of $2,500, or $250, in interest. Thus, the actual profit is $5,000 minus $250 in interest and any commissions. Even if the investor lost money on the trade, the loss would be increased by $250 plus commissions.
FAQs
Is it possible to lose all your money when trading on margin?
Yes, you can lose more than all of your money on margin. For example, if you make a trade by borrowing 50 per cent on margin, half of the trade is funded with borrowed capital. If the stock you invested in loses 50 per cent of its value, you would experience a 100 per cent loss in your portfolio. Including any commissions and fees, you would end up losing more than the money you initially invested, potentially owing money you don’t have.
Can the value of stocks drop to zero?
Yes, any stock can go to zero. While it is highly unlikely for a stock to become worthless, it is possible, especially if the company goes bankrupt. If you own a stock that falls to zero, you would lose the entire amount you invested in that stock.
What are the potential drawbacks of using margin in trading?
Margin trading has several disadvantages. The primary one is magnified losses: since you are borrowing money to increase your returns, any losses are also amplified. If a trade goes against you, you must repay the borrowed money, cover your losses, and pay commissions and fees. Additional disadvantages include interest charges that reduce your returns, margin calls requiring you to provide more capital, and forced broker liquidations that may result in further losses.
Conclusion
Margin trading carries significant risks because losses can be magnified. Despite being regulated with numerous rules, it should be undertaken only by experienced traders who thoroughly understand its mechanics, requirements, regulatory aspects, and the potential for substantial losses.
DISCLAIMER: This article is for informational purposes only. AVANTE PARTNERS is not involved with the Australian stock brokerage industry. Consult your stockbroker.
