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Signing up for a brokerage account is a big step in your investing career. There are several options for you to pick from in terms of investment accounts.
You could have a Roth IRA, Traditional IRA, 401(k), 403(b), a 718(r), and the list goes on. OK, that last one was made up.
When you sign up for a brokerage account, though, it opens up your opportunities to potentially have more control over your investments and your future.
However, it’s important to know that there are two types of brokerage accounts. One is a cash account, and the other is called a margin account.
Let’s focus on margin accounts because it comes with a bit more responsibility than a cash account.
What is a Margin Account?
A margin account allows you to borrow money from the broker to open larger positions than you would only using your account balance.
While it means you’d be taking on more risk, it also means that you could potentially improve your profit potential on your investments.
Don’t get too ahead of yourself, though. These accounts are riskier for the broker, so they usually come with some additional requirements.
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How to Use a Margin Account
Margin accounts are not relegated only to the best brokerage accounts. You can open a traditional IRA, Roth IRA, Rollover IRA, or some others as margin accounts.
Most of the larger brokers and investment firms might require as little as $2,000 to open a margin account.
Once you’ve deposited the money and start opening positions, the broker has a minimum percentage of the total account value, sometimes known as the net liquidity, that must be maintained.
Otherwise, you risk receiving a margin call. Remember that your net liquidity will keep changing as your account goes up and down.
Many larger brokers and investment firms have something along the lines of a 30% minimum, but this can change as your account value goes up and down.
Margin trading is, at its core, like taking out a loan. Banks are more than happy to lend money to you, but you’d better believe they’ll be charging interest on the margin you use.
These rates can be a bit high, though they decrease as the loan amount increases. As an example, one bank reviewed had a base lending rate of 5.25%, and the rate for less than $25,000 was base + 3.375% or 8.625%.
While some banks charge interest on loans to increase your margin, some banks or brokers will offer individual margins.
Basically, it could amount to up to 50% margin on each position opened, and they do this for the cost of commissions and 0% interest.
On equity (stock) trades, most brokers have been forced to a new industry standard of $0 commissions on equity trades.
That would mean, in some cases, you could trade with 50% margin for free.
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Example of a Margin Account
Let’s see how margin works in real life.
You’d like to buy 500 shares of XYZ at a price of $50.00 (for simplicity’s sake). A cash account would normally require you to put up $25,000 to open the position.
If you have a margin account, you can use a 50% margin scenario where you only have to put up $12,500, and the broker puts up the remaining $12,500.
If the stock price goes up to $60.00, then the position value goes up to $30,000. Let’s say you close the position here, happy with your profits.
You would give back the broker’s $12,500, leaving you with $17,500, a profit of $5,000! This doesn’t include interest charges, and those depend on the length of time that you held on to the position and the margin.
If the stock goes down to $40.00, and you decide to close the position at a loss, the position value would be $20,000.
You would still have to pay back the broker’s $12,000, plus any interest charges (depending on how long you held onto the position). This leaves you with less than $7,500 after interest, a loss of a bit more than $5,000.
>> More: What Is Margin?
Risks of Using a Margin Account
Margin can be great at increasing your profit potential. However, you must remember that you’re paying interest for the privilege of borrowing more money than you actually have.
This can get dangerous if you don’t have a proper plan for the position. Every investment carries the risk of going to zero, so you have to consider when you choose to take out a margin loan.
If the position goes against you, you could receive a margin call, requiring you to put more money into the account, close the position immediately, or close other positions to meet the margin requirements.
If you don’t do any of these, the broker will usually close the position for you. It only gets messier after that, depending on the size of the loan and how much further the position fell in value while the broker waited for you to respond.
Margin Account vs. Cash Account
While a margin account allows you to trade with the broker’s money, a cash account is simply one where your account balance is all the buying power you have.
If you buy $5,000 worth of a stock, your investable funds (also called your buying power) fall by $5,000.
This might reduce your risk, but your profit potential is lowered considerably.
Margin Account FAQs
Is a margin account a good idea?
That depends partly on your ability to meet the requirements of a margin account. More than that, it depends on personal preference.
If you don’t understand margin or have a clear position sizing strategy, then margin might not be the best idea.
If you have a clearly defined strategy or study your stock positions regularly, the margin might improve your returns.
However, it’s worth noting that the longer you intend to hold a position, the less appealing the margin will be due to the margin rates.
What is the difference between a cash account and a margin account?
A margin account allows you to trade your broker’s money in support of your own. On the other hand, a cash account will put only your money up when you open each position.
Should I do a margin or cash account?
A margin account can be a good idea if you can meet the minimum account requirements and have a good strategy.
If you only want to buy stocks and hold them for a very long period of time, or you don’t have a firm grasp on margin, then a cash account might be the best bet.
What are the risks of a margin account?
You take on more risk with a margin account, especially the higher amount you take out as a margin loan.
If you receive a margin call, you stand the chance of getting locked into a guaranteed loss in addition to covering any further losses that occurred between the margin call and the broker closing out your position.
Bottom Line: Margin Account Definition
Margin should be viewed as a tool. It can help leverage your money-making capabilities, but only as long as you understand how to use it, when to use it, and how to manage things if they go poorly.
The first step to opening a margin account is always to read deeply into your institution’s fee structure to find out the rates and generally understand all the requirements associated with a margin account.
Also, remember that some brokers offer margin for free in some instances. Again, do research before making a decision.