Definition of a Margin Trading Account

A margin account allows traders to borrow part of the cost of stock investments.

A margin trading account is one type of account an investor can set up with a stock broker. Margin trading offers an investor the opportunity for larger profits as well as the risk of greater losses. Margin accounts allow investors to borrow money for investing and are governed under strict rules from the Securities and Exchange Commission.

Function

A margin account from a stock broker allows an investor or trader to borrow a portion of the cost of stock investments from the broker. The term "trading on margin" means the trader uses a margin loan from the broker to pay for a portion of a trading position. The broker earns interest on the money lent to buy stocks. A trader does not need any further form of loan approval to borrow money in a margin account to trade stocks. The short selling of stocks can only be done in a margin account.

Potential

A margin trading account allows the trader or investor to borrow up to half of the purchase price of a stock investment. If the investor wants to buy $10,000 of a specific stock, she could borrow $5,000 as a margin loan and would be required to deposit or have in her account the other $5,000. If the value of the stock increased to $11,000, the trader would have a gain of $1,000. This $1,000 gain is a profit of 20 percent on the $5,000 the trader invested compared to a 10 percent gain if she had paid the full $10,000 to buy the stock.

Features

There are several important features of how a margin account works. The rules for margin accounts are set by the Securities and Exchange Commission--SEC--and the Financial Industry Regulatory Authority--FINRA. An individual brokerage company can choose to impose tighter restrictions on margin accounts. The initial margin limit is 50 percent of the purchase price. This means a trader can take a margin loan for up to half of the purchase price when a stock is bought. After the stock is purchased it can fall in value. Margin requirements limit how far the stock can decline before the investor must deposit more cash. This maintenance margin requirement is 25 percent. The investor's share, or equity, of the value of investments purchased on margin must be at least 25 percent of the investment value. Investor equity in a margin account must be at least $2,000.

Considerations

Investor equity is the investor's value of a margin trade. Equity is the current value of the security in the account minus the margin loan. For example, a trader buys $100,000 worth of stock with $50,000 in investor equity and a $50,000 margin loan. The value of the stock falls to $60,000. The margin loan is still $50,000, so the investor equity is now just $10,000. The investor would receive a margin call from the broker to bring his equity up to at least 25 percent. In this case the investor would need to deposit $5,000. The $5,000 would reduce the loan balance to $45,000, the stock value would still be $60,000, bringing the investor's equity up to $15,000 or 25 percent.

Warning

The stock brokerage company has the right to sell any and all securities in a margin account to pay down the loan balance if the account falls below the required equity minimums. If a broker issues a margin call for more cash to be deposited, the trader usually has two to five business days to deposit the money. However, FINRA notes that the broker has the right to sell securities at any time if the investor equity has continued to decline, even after a margin call has been issued. Traders with margin accounts need to monitor their stock values closely and be ready to deposit cash or sell positions before the broker sells securities without consulting the trader.

References

• Investopedia: "Margin Trading, What is Buying on Margin?"
• SEC: "Margin, Borrowing Money to Pay for Stocks"
• FINRA: "Understanding Margin Accounts"