Investors in the stock market are always looking for ways to boost their returns. In most cases, this means taking on extra risk in some form.
Margin accounts are one way many veteran investors attempt to boost their returns - it involves some risk, but less than other strategies.
NOTE: Using margin is not for beginners in the stock market. If that's you, this article will help you understand what margin is and how it works. It is not something you should try early in your investing experience.
Margin accounts allow you to borrow money to buy stock, which is a great deal if the stock goes up, but can be a disaster if the stock heads south.
Margin trading uses the power of borrowed money to magnify how much you can buy in your account. Your broker lends you the money because they want your trading business.
How to Set Up a Margin Account
To use margin you must set up a margin account, which is different from a regular trading account at a broker. Most brokers will check your credit and ask about your level of investment knowledge before opening a margin account.
Margin accounts require an initial deposit, which can range from $2,000 to $5,000 and up depending on the broker. This initial deposit also called the minimum margin sets your starting point for trading. If you deposited $2,000, you would have $4,000 of buying power (your $2,000, plus $2,000 from the broker).
You can margin up to 50% of a stock's price in most cases. For example, if you wanted to buy 100 shares of a stock selling for $20 per share for a total of $2,000, you could margin $1,000 of the purchase price. In other words, you would use $1,000 of your money, known as the initial margin, and the broker would loan you $1,000.
You don't have to borrow up to 50%, but that is as high as you can go. Some stocks may have lower limits and some brokers might not let you margin up to 50%.
You now own 200 shares worth $2,000, but have only invested $1,000 of your money in the deal. If the stock goes up to $25 per share, your holding is now worth $2,500, - a nice return on $1,000 invested. If you sell and repay the broker, you are left with a $500 profit (ignoring fees and interest for the sake of illustration), which gives you a 50% return.
In a regular cash account, you would have invested $2,000 of your own money to earn $500 - a 25% return.
However, if the stock goes down to $5 per share, your holding is now only worth $500 and you still owe your broker $1,000, plus interest. Expect a phone call from your broker soon.
The call will come because you have to maintain a minimum account balance or maintenance margin as part of your agreement with the broker. The maintenance margin says you must keep your account balance above a certain level.
If the account balance falls below that level, which might be from 30% to 40% of the original balance, the broker will issue a margin call. The margin call requires you bring the account back up to the maintenance level.
You can do that by depositing more money in the account or by selling the stock. In extreme circumstances, the broker may sell the stock out of your account without consulting you.
Conditions and Restrictions
Margin trading has some other restrictions and conditions:
- Your broker will charge you interest on the money you borrow, so only use margin for short-term trading positions. If you hold a margined stock for a lengthy period, the interest charged by the broker may eat up all or most of any potential gain.
- Not all stocks are eligible for margin trading. You can't buy penny stocks, OTC stocks, IPOs and others on margin. Check with your broker for more complete information.
- When you sell stocks bought on margin the money goes into the margin account to settle the loan to the broker. Any excess is available for withdrawal.
- Not all margin accounts and agreements are the same. Read the complete agreement and make sure you understand it before signing up with a broker.
- Margin trading is not for beginners. It is one of the few ways you can lose more than you invested if things go bad, since you must repay borrowed money.
For knowledgeable, short-term traders, margin provides a way to magnify your trading power. However, it is a risky business best left to experienced investor because missteps can be extremely costly.