Margin Account - Explained
What is a Margin Account?
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Table of ContentsWhat is a Margin Account?How Does a Margin Account Work?Illustration of the Working of a Margin Account
What is a Margin Account?
A margin account is a type of brokerage account that allows the investor to utilize a cash loan from the broker in addition to his own funds in order to purchase stocks or other financial products. Margin accounts are typically used by investors that are confident about particular stocks rising in value, but are unable to purchase a satisfactory quantity of such stocks due to the lack of sufficient funds in their brokerage accounts. The cash borrowed from the broker is treated as a regular cash loan and includes a periodic interest rate. Moreover, the investor is also liable to pay for other costs such as commissions and fees. Although, in an ideal scenario, the investor stands to multiply his profits, in more realistic terms, margin accounts are extremely risky and in several occasions, have resulted in magnification of losses for the investors. As such, a majority of investors consider margin accounts unnecessary.
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How Does a Margin Account Work?
The rationale behind using a margin account is described as follows:
Any investor that purchases securities with margin funds will tend to earn much better total returns from his investments than he would have been able to if he had only utilized his own cash to purchase securities. This is of course assuming that the stock appreciates in value over time and that such an appreciation is beyond the interest rate paid to the broker.
Besides leveraging returns, there are two other reasons why an investor might opt for a margin account. They are:
- To maintain positive cash flow, while waiting for trades to settle.
- To create a de facto line of credit for working capital requirements.
The obvious downside to such an arrangement is that the investor has to shell out interest on the margin funds at steep rates for the entire term of the outstanding loan. This invariably adds to the cost of owning such securities. Moreover, in the event that the stock declines in value, the investor will not only be forced to realize the losses on his investment, but will also need to pay interest to the broker, besides other fees and costs. In case declining share prices cause the margin accounts equity to drop below the maintenance margin level, the brokerage firm will initiate a margin call to the investor. A margin call means that the investor would be required to deposit additional funds in the brokerage account or sell the requisite quantity of stock within a time period of (usually) three days, in order to increase the margin accounts equity above the maintenance margin. A brokerage firm is within its rights to ask the investor to increase his funds in the margin account. It might even choose to sell all or part of the investors securities if it senses a risk to its own investments. Failing to fulfill a margin call or carrying a negative balance in the margin account will, most certainly, result in a lawsuit initiated by the brokerage firm against the investor.
Illustration of the Working of a Margin Account
Let us assume that investor I1 wishes to purchase 500 shares of company C1 at the rate of $10 per share, by using $5,000 of his own money that he has placed in a margin account with broker B1. Now, suppose I1 wants to double his portfolio of C1 shares by using additional margin funds of $5,000 supplied by B1. So, now I1 has 1,000 shares of company C1 worth a total of $10,000. In the event that C1s share value appreciates to $20 per share, I1 would be able to sell his entire stock of C1 shares for $20,000. Now, after repaying the additional funds worth $5,000 sourced from B1, as well as separating his original investment of $5,000, I1 will make a net profit of $10,000 (not counting fees and commissions). From the above scenario, it is easy to note that although I1 ended up with a $10,000 profit by only parting with $5,000 of his own money, without a Margin Account, he would have only been able to make $5,000 in profits. However, stocks do not always appreciate in value. Let us assume that post I1s purchase of 1,000 shares worth a total investment of $10,000, the share price of C1 halved to $5 per share. In such an event, I1 would lose the entirety of his investment and invoke a margin call. This is because the total value of the stock would drop to $5 x 1000 = $5,000, which the broker B1 would take back as repayment for his original loan. B1 would also notify I1 about making further investments into the margin account, failing which his position would be considered closed. Now, realistically, a Margin Account involves costs payable by the investor in the form of commissions and interest on the borrowed funds. In the above example, assuming that the entire trade of shares occurred over a year, and that broker B1 charges an interest rate of 10 percent per annum, the investor I1 would have to pay 10% of $5,000, i.e. $500 as interest. Thus, in the event that I1 made a profit of $10,000, his actual profit would be $10,000 - $500 - the commission amount. Even in the event that I1 lost his entire investment, he would still have to pay an additional $500 plus commissions to broker B1.