A margin account is a special brokerage account that allows the account holder to borrow money from the broker for investment purposes, with the equities and other holdings serving as collateral. Creating a margin account usually requires the execution of a special margin agreement, which sets the conditions by which the account holder may borrow and the broker may collect.
Function
- A margin account is the most common way for the average retail investor to obtain leverage on their initial deposit, possibly increasing their profits significantly. It also creates revenue for the broker because they often collect a modest rate of interest on the margin loan. These are almost always good loans for the broker because they are secured by the asset value of the account, making collection fairly easy.
Features
- According to Regulation “T” of the Federal Reserve Board, investors can borrow up to 50 percent of the purchase price of securities through a margin account. Individual brokers may set forth additional restriction or regulations in the margin agreement. The agreement will also set forth a minimum maintenance level, usually in the vicinity of 25 percent, and usually reserves the right of the broker to change this level at any time.
Warning
- While a margin account can increase an investor’s buying power and profitability, it can also intensify the risks. Margin accounts allow the broker to liquidate assets in a portfolio without notice if the account value falls below the maintenance level. Though the account holder may, in some case, be given an opportunity to satisfy a “margin call” before the broker takes unilateral action, if assets are liquidated, they cannot prioritize which are sold first. And, because the margin call usually occurs when assets are below normal valuations, holdings are often sold for less than what the account holder may have otherwise accepted.
Effects
- Another effect of executing a margin agreement is the ability to make short sales. Shorting a stock creates a liability to buy the stock back at a future date. If the price is lower, the short seller keeps a profit. If the price is higher, however, the difference is a trading loss. And, because there are no limits to how high a stock can go, short sales theoretically infinite risk of loss. As a result, most brokerages will require a margin agreement to allow short sales and treat them as a loan.
Considerations
- In some cases, a margin agreement can result in an investor having a negative balance and owing more than their initial deposit. This occurs if the total asset value of the account falls below the amount of the margin loan. The broker will sell whatever assets it can and debit the account holder for the remaining amount due. Trading on margin, therefore, carries significantly more risk than normal investing and can result in an account being completely wiped out or worse. If the broker is forced to litigate as part of the collections process, or take on other costs, the margin agreement will usually stipulate the account holder is also liable for these additional expenses.
