Understanding Margin Accounts
Before an investor can short stocks or execute certain options trades, they must open a margin account. This is a special brokerage account allowing the account holder to borrow money from the broker for investment purposes, with the value of the account serving as collateral on the loan. Creating a margin account requires the execution of a margin agreement setting forth the conditions of the loan.
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Function
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A margin account is a great way for the retail investor and institutional trader alike to obtain leverage on their funds and, hopefully, increase their profitability. Margin accounts also maximize revenue for the broker, who collects a modest rate of interest on the margin loan. These are almost always sound loans for the broker because they are secured by the asset value of the account, making collection fairly easy.
Features
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By law, investors can borrow up to half the purchase price of securities through a margin account. Individual brokers may further restrict or modify the terms through the margin agreement. The agreement will also set forth a minimum maintenance level, and usually reserves the right of the broker to change this level at any time. If the investor's equity in purchased assets falls below the maintenance level, the broker is able to liquidate the account without notice. A "margin call" gives the account holder the opportunity to meet the maintenance requirements without intervention by the broker.
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Warning
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Values in a margin account can change quickly. The value of the outstanding loan remains constant, but the assets purchased fluctuate daily, and only the equity invested by the account holder count toward the maintenance requirement. For example, $10,000 of assets purchased with a 50 percent margin loan, has a margin equity of $5,000. If the maintenance requirement is, say, $3,500, a margin call would be generated if the total value of the assets dipped below $7,000. Over time, interest on the loan will also eat into margin equity.
Effects
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A powerful effect of executing a margin agreement is the ability to make short sales. 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. Some options strategies, generally anything that requires the sale of puts, can only be ordered through a margin account.
Considerations
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In the worst case scenario, the total asset value of the account falls below the amount of the margin loan. The result is the investor has a negative balance, having lost more than their initial deposit. The broker will sell all the assets it can and debit the account holder for the remaining amount due. If the broker is forced to litigate or assume other costs as part of the collections process, the margin agreement will usually stipulate the account holder is also liable for these additional expenses.
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