What is a Margin Account
A margin account is a brokerage account in which the broker essentially lends the customer cash to purchase securities. The loan in the account is collateralized by the securities purchased and cash, and comes with a periodic interest rate. Because the customer is investing with borrowed money, the customer is using leverage, and will magnify both losses and gains because of it.
BREAKING DOWN Margin Account
A margin account lets an investor borrow money from a broker to purchase securities up to certain limits. For example, an investor with $2,500 in a margin account wants to buy Company A’s stock for $5 per share. The customer could use additional margin funds of $2,500 supplied by the broker to purchase $5,000 of Company A’s stock, or 1,000 shares. If the stock appreciates to $10 per share, the investor can sell his shares for $10,000. If he does so, after repaying the broker's $2,500, he will have profited $7,500, assuming no other costs. In reality, the investor will also have to pay interest on the margin lent to him by the broker, as well as other trading costs, so his profit will be less.
Margin Account Pros and Cons
If an investor purchases securities with margin funds, and those securities appreciate in value beyond the interest rate charged on the funds, the investor will earn a better total return than if he had only purchased securities with his own cash. This scenario is 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, increasing the investor’s cost of buying the securities. If the securities decline in value, the investor will be underwater on the margin funds, and will have to pay interest to the broker on top of that. In addition, if a margin account’s equity drops below the maintenance margin, the brokerage firm will make a margin call to the investor. Within a specified number of days, typically within three days, the investor must deposit more cash or sell some stock to offset all or a portion of the difference between the security’s price and the maintenance margin.
A brokerage firm has the right to increase the minimum amount required in a margin account, sell the investor’s securities without notice or sue the investor if he does not fulfill a margin call. Therefore, the investor has the potential to lose more money than the funds deposited in his account. For these reasons, a margin account is most suitable for a sophisticated investor with a thorough understanding of the additional investment risks and requirements.
Federal Regulations on Margin Accounts
A margin account may not be used for buying stocks on margin in an individual retirement account, Uniform Gift to Minor accounts, a trust or other fiduciary accounts, as 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, 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.