What is Margin Lending?
A margin agreement is a legal contract between a broker and an account holder, the terms of which make it possible for the account holder to borrow money from the broker for investment purposes. Trading on margin creates a consensual lien against the account and sets the conditions by which the broker may collect on the loan or settle any disputes.
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Features
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According to Regulation T of the Federal Reserve Board, investors can borrow up to 50 percent of the purchase price of securities. Individual brokers may set forth additional restriction or regulations in their margin agreement, usually in the form of a maintenance equity level. Under this requirement, the value of the account holder's equity--an amount equivalent to the total value of the account's securities less the principal of the margin loan--must be at least a fixed percent of the total value of the securities, often in the vicinity of 25 percent. In almost all cases, the broker reserves the right to change the maintenance requirements at any time.
Benefits
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The immediate benefit of executing a margin agreement is the ability to make short sales and effectuate certain options trades. Short sales theoretically carry infinite risk of loss since there are no limits to how high a stock can go, so most brokerages will require a margin agreement and treat them as a loan. For similar reasons, any options strategy that involves the sale of puts can only be initiated through a margin account. But beyond these permissions, the benefit of a margin agreement is obviously the ability to buy more with less, potentially increasing profits.
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Function
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While margin lending is a common way for average retail investors to obtain leverage on their capital, it also creates revenue for the broker, who collects interest on the margin loan. Since the margin loan is secured by the assets of the trading account, these are almost always good loans for the broker, and collection is fairly easy.
Warning
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Margin agreements allow the broker to liquidate assets in a portfolio without notice if the margin equity 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, the account holder is not able to choose 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.
Considerations
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Margin lending can result in an investor having a negative balance and owing more than his initial deposit. This occurs if the total asset value of the account falls below the principal of the margin loan. After issuing a margin call, the broker will liquidate the account's assets, withdraw the proceeds, and debit the account holder for the remaining amount due. 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.
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- Photo Credit Jeremy Kemp
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