The Magic of Margin: What You Should Know About Margin Accounts
Margin accounts allow investors to increase the amount of securities they hold in their brokerage accounts by borrowing from the brokerage firm to purchase additional securities. This allows investors to leverage their returns, although they are simultaneously leveraging their risk.
Investors have two basic forms of brokerage accounts available: a cash account and a margin account.
A cash account allows the investor to purchase securities for which they have cash in the account to pay.
A margin account allows the investor to purchase securities using not only the funds they have in the account but also using money borrowed from the brokerage. The loan from the brokerage is secured by the investments in the account.
Margin Account Eligibility
Having a margin account is a privilege for which you need to apply. The brokerage firm will check your financials including your income and assets, possibly your credit, to determine your ability to repay borrowed funds.
The investor has to be eligible, the account has to be eligible, and the investments have to be eligible.
Not all accounts can be margin accounts: Uniform Gift to Minors Act accounts, Uniform Trust to Minors Act accounts, individual retirement accounts, and qualified accounts are generally not eligible for margin.
Not all investments can be purchased on margin; they must be qualified investments for margin purposes.
Generally stocks listed on the New York Stock Exchange will be marginable, as will most stocks on other major exchanges, most bonds, and exchange traded funds.
Mutual funds can’t be purchased on margin but can generally be collateral for the account if they have been held by the investor for at least 30 days. Most margin accounts will not allow for initial public offerings to be counted for margin purposes until they have been publicly traded for at least 30 days.
How Margin Works
Margin is a return magnifier. It makes gains greater and it makes losses greater.
Here’s an example. Suppose you want to purchase ABC stock at $100 per share. You have $5,000 in a margin account and ABC is a marginable security. You borrow $5,000 from the brokerage to purchase 100 shares of ABC for a total of $10,000.
Let’s say ABC doubles in value to $200 per share. Your investment is worth a total of $20,000. Your return is not the 100 percent increase; it is 300 percent. You have $20,000 worth of stock and a $5,000 loan for a net equity of $15,000 from your $5,000 investment. We’re leaving fees and costs out of the picture for now.
This can work both ways. Let’s say you did the same thing but instead of ABC doubling it drops 75 percent to $25 per share.
You now have an account value of $2,500 and a loss of $7,500 on your investment — you lost more money than you put in. Your loss is 150 percent of your initial $5,000 investment.
Margin increases your risk beyond the amount you have in the account; you can possibly lose not only what you put in the account but also what you borrowed as well.
It magnifies both the good and the bad. In the example, we did not consider trading costs and interest costs. These costs would detract from the gains and exacerbate the losses.
Regulation of Margin
Margin accounts are heavily regulated.
The basic regulations are established through the Federal Reserve Board’s regulation T and by the Financial Industry Regulatory Authority (FINRA). Brokerage firms often have more stringent rules, but cannot have less stringent ones.
The Fed’s regulation T requires that an initial margin position can’t be more than 50 percent of the account equity. This effectively allows you to borrow an amount equal to the cash and qualified investments you have in the account.
FINRA requires a minimum of $2,000 in equity for a margin account, and the equity has to be maintained at 25 percent or more of the account value. This is commonly referred to as the maintenance equity, as opposed to the 50 percent required for initial equity. If you fall below this value, your account will be subject to a margin call.
A margin call occurs when your account falls below the minimum maintenance equity level of 25 percent established by FINRA, or a higher level established by your brokerage firm.
You may be provided a small window of time to correct — but you may not be. Correction could mean adding cash or additional marginable securities, or selling securities to reduce the loan balance and increase the equity percentage.
The brokerage firm has the right to sell securities in your account to meet the required minimum equity.
They have the right to determine which securities to sell without your input or consent — you gave your consent by signing the account agreement when you established the account. This can impact you negatively from an investment standpoint or from a tax standpoint or both.
The key, as an investor, is to not let this happen. Margin investors need to monitor their accounts closely to make sure they don’t get into a position where a margin call becomes a realistic possibility.
With the potential to lose more than you invested and have a brokerage selling what you don’t want to sell, you have to wonder why someone would do this in the first place! Margin investing can be an appropriate tool for some investors.
Why Investors Use Margin Accounts
Margin accounts are not for everyone. They absolutely increase the risk while potentially increasing the return.
An investor who uses a margin account prudently has the potential to improve their long-term returns beyond what they could possibly achieve without margin.
That’s its attraction. Leverage is simply a wonderful tool — a dangerous tool if used improperly — but still a wonderful tool when it achieves what you want.
Some investors may also be able to deduct their margin interest expenses on their taxes. Investment expenses are an itemized deduction and not everyone will garner a tax advantage from this expense.
Margin can provide a source of funds for use other than purchasing additional investments. There is still the amplification of risk; you can lose and need to come up with additional funds to meet a margin call.
Investors may use a margin loan for virtually any purpose. They could be consolidating some higher interest debt, or using it as an alternative to traditional financing.
Some investors use margin to postpone tax consequences for a sale, using the margin loan as a bridge and then making the sale in the following tax year to repay the loan. It can also be a source of funds for business needs or as a cash flow bridge.
The Bottom Line
Margin investing is not for everyone. You should not consider margin if you are not in a financial position to weather the losses margin can produce.
You should not consider margin if you are a risk-adverse investor who becomes anxious at every little blip in the market. You should not consider margin if you do not have considerable investing experience and a history that supports achieving long-term growth. That’s a lot of “should nots” — which leaves far fewer “shoulds.”
Prudent long-term investors can potentially achieve greater results through the appropriate use of margin.
Others may be able to benefit from a margin account; sometimes its best use for an investor is as a source of funds for other short-term needs.
While there is increased risk, that doesn’t mean margin is always a bad idea; it is a tool that can hurt you and you have to use it carefully. For those who are comfortable and qualified, margin increases their investing options — and that’s never a bad thing.