What is a Margin Account?
Margin Account Overview
A margin account is a brokerage account where the broker loans the customer cash to purchase securities so that the customer does not need to put up the entire value of a trade.
A margin account allows a customer to trade stocks, futures and options.
The margin loan typically comes with a fee or interest rate on the borrowed funds.
The customer is investing with borrowed money, using leverage which will magnify profits and losses.
If an investor purchases stock with margin funds and that stock appreciates beyond the interest rate charged on the funds, the investor will earn a better return than if they had purchased securities with their own cash.
If an investor purchases stock with margin funds and that stock depreciates in value, the investor will incur a loss and will additionally have to pay interest to the broker.
If a margin account’s value drops below the maintenance margin, the brokerage will issue a margin call to the customer. The customer must deposit more cash or sell securities to offset the difference between the security’s price and the maintenance margin.
If the customer doesn't deposit more cash or sell securities following a margin call, the broker will sell some of the securities in the account to make up the difference. The broker does not need the customers approval to satisfy a margin call.
Example of a Margin Account
An investor with $5,000 in a margin account wants to buy Acme stock for $10 per share. The customer could use margin funds of up to $5,000 supplied by the broker to purchase $10,000 worth of Acme, or 1,000 shares. If the stock appreciates to $20 per share, the investor can sell the shares for $20,000. If they do so, after repaying the broker's $5,000, and not counting the original $5,000 invested, the trader profits $10,000.
Had they not borrowed funds, they would have only made $5,000 when their stock doubled. By taking double the position the potential profit was doubled.
Had Acme stock dropped to $5 per share, all the customer's money would be gone. Since 1,000 shares * $5 is $5,000, the broker would issue a margin call notifying the client that the position is being closed unless the customer puts more capital in the account.
This example assumes there are no fees. if interest is paid on the borrowed funds and the trade took one year at an interest rate of 10%, the customer would have paid 10% * $5,000, or $500 in interest. Their actual profit is $10,000 - $500, or $9,500. However, if the customer lost money on the trade, their loss is increased by the $500 interest fee.
-Happy Trading, Verdia