A brokerage may lend you cash to trade on stocks and other financial instruments. A brokerage account that facilitates this type of activity is the margin account. The loan you acquire can be categorized by the security purchased or the cash awarded. Margin accounts come with periodic interest rates. Since you are investing with borrowed funds, you are using leverage to magnify your profits and losses.
How Does a Margin Account Work?
To earn a return with margin accounts, the securities that you buy with margin funds have to appreciate beyond the value of interest charged. Trading with margin funds is more lucrative than trading with your own cash. This is the main advantage of using leverage accounts.
On the downside, a broker will charge interest on your marginal funds for as long as the loan is outstanding. This practice increases the cost of trading. If your securities depreciate or drop in value, you will find yourself underwater. In this case, you will be paying interest on top of the money you owe the broker.
A brokerage makes a margin call to you when a leverage account’s equity drops below the maintenance margin level. With a specified period (three business days or less), the broker will expect you to dump more money into your account or sell the stock to offset a portion or all of the difference between your security’s price and the maintenance margin.
A brokerage firm reserve the right to:
- Request a customer to increase the capital they hold in a margin account.
- Sue an investor when they are carrying a negative balance or if they do not fulfill a margin call.
- Sell an investor’s securities if the firm feels their funds are at risk.
As an investor, you run the risk of losing more money than the funds deposited in your margin account. Due to this risk factor, margin accounts are only suitable for sophisticated investors. You need a thorough understanding of the markets and a proper risk mitigation strategy.
You may not use a margin account to buy stocks on margin in a trust, IRA, or other fiducial accounts. Apart from that, you cannot use margin accounts with stock trading accounts of less than $2,000 in value.
Marginal Accounts and Leverage
Margin requirements and leverage ratios vary from broker to broker. The amounts typically offered in the industry are 10:1, 20:1, and 30:1. Leverage levels offered on margin accounts depend on trade size and position. A minimum margin requirement of 5% reflects 20:1 leverage. In the same breath, 10% will reflect 10:1 leverage.
Note that if you’re using a margin account to day trade the Pattern Day Trader (PDT) rule will be applied in certain cases.
What is a Margin Call?
When on a margin call, your risk levels are restricted. The margin call is the point where your equity (unrealized profit and loss + balance) is equal to the margin requirement. The stop-out level is the point when your equity is equal to half the margin required. At the stop-out, the broker will close your biggest losing position forcibly. Opening a position without enough equity to support the position is risking your account to a stop-out. In this case, the trading platform will close any or all open positions when the balance drops below the margin stop-out levels.
Example of a Margin Account and Margin Trading
An investor with $2,500 in a margin account wishes to buy Nokia’s stock at $5 a share. The investor could benefit greatly from $2,500 in margin funds. The investor acquires the margin funds, and he is able to buy $5,000 worth of Nokia shares (1,000 shares). A few years later, the stock appreciates to the value of $10 a share. Now the investor can sell the shares for $10,000. After repaying the broker $2,500, the investor will make $5,000 in profit (not counting his $2,500 initial capital).
Had this investor not have borrowed $2,500, he would have only made $2,500 in profits.
If the Nokia stock dropped to $2.5 a share, the investor would have lost all his money. How? A thousand shares trading at $2.5 each would be worth $2,500. At this point, the broker would have notified the investor that his positions risk closing unless he deposits more capital into the account. If the investor ignores this advice, he will lose all his funds; this is a margin call.
The example above assumes that the broker does not charge any fees. However, in the real world, interest is paid for borrowed funds. If the trade ran for one year at an interest of 10%, the investor would have to pay $250 in interest. In case of a profit, the investor will make a profit minus $250. In the case of a drop in share prices, the investor will have to pay $250 in addition to the money he owes.
What Do You Do When on Margin Call?
As an investor, you have two options. The first option is to close the positions immediately. The other is to deposit more funds into your margin account. Increasing your equity will support further losses and allow you to keep the positions open. You can also reduce the size of your positions to free up more equity.
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