Margin accounts are a type of brokerage account where the broker lends the customer cash to purchase securities. The loan in the account is collateralized by the securities and cash. If the value of the stock drops sufficiently, the account holder will be required to deposit more cash or sell a portion of the stock.
Before reading on, we strongly recommend reading the margin trading tutorial, which focuses on how margin calls work, how leverage can have advantages, and why using margin can be risky.
Opening a Margin Account
In a margin account, a broker-dealer lends cash to the client to buy securities. The client then pledges that the securities in the margin account may be used as collateral for the loaned money with which they were bought; this arrangement is called hypothecation, and it ultimately means the broker-dealer can sell these securities to cover the loan under certain circumstances. It also means the broker-dealer can pledge those securities residing in a client's margin account as collateral for its own obligations, in a process called rehypothecation.
Trading with a Margin Account
Most stocks are marginable provided they are trading over $5 per share. All marginable stocks require an initial margin of 50% of the total purchase or short-sale price.
Most government and corporate bonds are also marginable: Treasury instruments start at 3% initial margin requirements, and investment-grade corporate non-convertible bonds start around 30% initial margin.
Potential Consequences of Margin Accounts
The bane of traders is the margin call, which is generated when an investor purchases positions worth more than her buying power. These calls must be met - that is, the investor must make an adequate deposit of money or marginable securities to satisfy maintenance margin requirements - on the settlement date of the transaction that triggered it, usually three days after the trade date. If the maintenance margin requirement has not been covered by five days after the settlement date, the account can be frozen. The funds can come from a deposit or from cash dividends, earned interest or liquidation of securities in the account.
Margin Account Restrictions
There are other restrictions on the use of margin. IRAs and custodial accounts for minors, which were discussed in earlier chapters, are ineligible for margin and must be structured as cash accounts. Margin accounts cannot be used to buy either initial public offerings (IPOs) of stock or stocks trading under $5 per share.
- Options can be purchased on margin, but broker-dealers often require a certain account balance far above that required for strict stock players before permitting options trading.
- Every NYSE-member broker-dealer is required to have management in place to ensure that its registered representatives have gathered the essential facts relative to every customer, every order, every cash or margin account, and every person holding power of attorney over an account.
These managers must also specifically approve, in writing and based on knowledge of pertinent facts, the opening of an account prior to or promptly after the completion of any transaction for the customer.
Managing Margin Accounts
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