Investing is often considered a great way to start growing your wealth. Over long periods, long-term diversified investments usually have a strong track record of providing decent returns.
Unfortunately, knowing how to invest money amid the volatility of the stock market can seem challenging. Vast amounts of information and investing strategies compete for your attention. It’s hard to know which sources offer reliable advice and which may set you up for failure.
As someone just starting their investing journey, you may have come across the concept of a margin account. These accounts are complex and require you to learn some advanced concepts before you begin using them. Here’s what you need to know before you consider opening a margin account of your own.
What is a margin account?
A margin account allows you to invest in marginable securities (tradable financial assets that can include stocks, mutual funds, exchange-traded funds (ETFs), or other investments) using a mix of your own cash plus money you borrow from a brokerage firm, called margin. This differs from a cash account, which only allows you to invest the money you deposit.
The debt you borrow using a margin account increases your purchasing power and allows you to invest more than you could on your own. Margin trading isn’t free, though. Brokerages charge an interest rate on the margin debt you take out and will likely have specific requirements you must follow as well.
It’s important to understand that investing using margin adds more risk than traditional investing. You could end up losing more money trading on margin than investing with cash. That said, margin trading could provide better returns if your investments perform well. This happens because using a margin allows you to invest more money upfront.
Common margin trading terms you should know
When investing with margin, here are some of the most common phrases you should know:
- Equity: The value of an account you own after accounting for any margin loan. If your account holds $20,000 in securities and you took out a $5,000 margin loan, your account value is $15,000 in equity, and it is 75% equity on a percentage basis.
- Initial margin or initial required margin: The minimum amount of equity you must have in a position (the amount of a particular security you own) at the start of a margin trade, usually 50% or higher.
- Maintenance margin: The percentage of equity you must hold in your brokerage account to avoid a margin call. This equity requirement is normally 25% or higher.
- Margin call: The requirement to add cash or sell investments to meet or exceed the maintenance requirement.
- Minimum margin requirement: The initial amount you must deposit to open a margin account, typically $2,000 or higher.
Margin trading examples
Margin trading could provide big windfalls or outsized losses for securities traders. To illustrate this point, these examples show the vast differences in returns margin traders can face.
A cash trader might decide to purchase 200 shares of a security for $25 each. To make this purchase, they need to pay the full $5,000 purchase price in cash. If the security skyrockets to $50 per share, the investment is now worth $10,000 (200 shares x $50). This gives the investor a $5,000 gain. However, if it drops to $20, the investment is only worth $4,000 (200 shares x $20). This results in a $1,000 loss.
If a margin trader used the same $5,000 in cash plus an additional $5,000 in margin, they could buy 400 shares of the $25 security. If the security price doubles to $50, the investment would be worth $20,000 (400 shares x $50). The investor would receive a gain of just under $10,000 after paying off the margin loan plus interest charges. This is almost double the cash investor’s gain.
Unfortunately, if the security’s price drops to $20, the investment is now only worth $8,000. This is still more than the initial $5,000 cash investment, but due to the margin loan, the investor still has a $5,000 debt outstanding plus the margin interest owed. So the investor has put $10,000 plus interest into a situation that is now only worth $8,000.
At this point, the investor could sell their position. After paying off the loan and accounting for interest charges, the investor would have less than $3,000 left. In the cash account scenario, the investor loses only $1,000. But the margin investor loses over $2,000.
Margin trading regulations
Margin trading falls subject to regulation because of the uncertainty involved. In particular, the Federal Reserve Board defines requirements in its Regulation T that you must meet when investing on margin. One of the requirements prohibits investors from borrowing more than 50% of the value of the stock on margin purchases. Regulation T would prohibit an investor from borrowing $3,000 on margin when they’re only investing $2,000 in the position. This would result in only 40% equity and 60% margin. However, you could borrow $2,000 on margin based on a $2,000 investment in the position.
The Financial Industry Regulation Authority also regulates margin trading. FINRA sets a requirement of having a $2,000 minimum cash deposit before you can open a margin account with a brokerage. Another FINRA rule requires investors to keep a minimum of 25% equity in their margin account.
These rules and regulations help prevent investors from getting in over their heads. They provide a barrier to entry and help avoid overly speculative trades that could result in massive losses if the securities don’t perform as expected. The rules set by the Federal Reserve Board and FINRA are only minimum requirements. Brokerage firms can also impose stricter standards.
How do margin calls work?
Margin calls are one of the significant downsides of margin investing. They are part of your margin agreement and exist to protect you and the brokerage firm. Margin calls happen when your investments decrease in market value to a point where your account’s equity is lower than the maintenance margin required. If your firm has a required maintenance margin of 25% and your equity drops to 20%, that shortfall would make you subject to a margin call.
When this happens, a brokerage will require you to put more cash into your account or sell investments in order to keep your maintenance margin at or above the required percentage. In some cases, brokerages will give you a warning. They may allow you to add cash or choose which securities to sell. They don’t have to warn you, though.
Brokerages may be able to choose to sell any investments in your account to return your account to the proper maintenance margin requirements. A margin call may also happen when a brokerage decides to raise your maintenance margin to an amount higher than your current equity in your account.
If the sale of your securities doesn’t provide enough money to pay off the margin loan in full, including interest charges, you may still owe money to the brokerage firm. You must have enough cash on hand to pay off the debt or you risk damaging your credit score.
Setting up stop-loss orders could help you avoid margin calls. These are trades you can set up in advance. They execute and sell securities if your investments drop to a specific price. For instance, you may have a security that is currently priced at $50 per share. You can set a stop-loss order at $40 to avoid steep losses on your trade. If the price drops to $40 per share, the order would execute and sell your shares at the market price.
By setting a stop-loss market order, you could limit your losses. Even so, these could also have dangers. If a stock price drops quickly, the stop-loss market order may not execute at your desired price. The trade may execute at an even lower price locking in larger losses than anticipated.
The benefits of a margin account
Even though margin trading creates uncertainty, it could help grow your investment account when things work out for the best. Here are the common margin account benefits:
- Could allow you to take multiple positions with a limited cash balance
- Increased buying power by borrowing money to invest in additional securities
- Potential for accelerated account growth
The risks of a margin account
The U.S. Securities and Exchange Commission issued an investor bulletin listing many of the risks. Here are some of the most perilous aspects of a margin account to consider:
- Brokerage firms may increase margin requirements, and require you to deposit more money even if value of the securities doesn’t fall
- Margin calls may force you to sell investments at less than ideal times
- Margin calls may require you to deposit additional cash on short notice
- You can lose more than you invest in stocks due to the margin debt aspect
- Your brokerage may sell investments you didn’t plan to sell without notice to satisfy a margin call
How to open a margin account
Some of the best investment apps allow margin trading, but not all do. Robinhood, Webull, and Ally Invest are some of the many providers that permit margin trading. But before you get started, make sure you have a thorough understanding of margin trading and its dangers.
First, choose a brokerage and open an account with the firm you want a margin account with. If you already have a brokerage account, check whether the firm offers margin trading accounts and their requirements for doing so.
Once you open the brokerage account, you must meet the firm’s margin requirements before applying for a margin account. This is typically $2,000 but could be more if your brokerage requires a higher minimum. Once you’ve met the minimum, you can apply for a margin account with the platform of your choice.
Are margin accounts a good idea?
Depending on your situation, a margin account could offer an opportunity to help you increase your returns. However, it could also magnify your losses. Carefully consider your situation because there are a number of risks involved. Opening a margin account could help you access opportunities you wouldn’t normally have, but you need to be aware of the potential downsides as well.
Does a margin account affect my credit score?
In general, your margin account shouldn’t impact your credit score. A broker might perform a credit check before opening a margin account, but the account itself likely won’t be reported to the credit bureaus. However, if the value of your account drops to a degree that selling off your investments won’t cover your loan and you don’t make payments, a margin account could be reported as a delinquent account.
Why do I have a negative margin balance?
A negative margin balance indicates the amount that’s on your loan. Until the loan is paid off, your balance will appear negative. This is also known as a debit balance.
Do you need margin to short a stock?
Yes, if you're interested in short selling, then you'll need to be able to trade on margin. The Federal Reserve’s Regulation T requires that you have a margin account in order to short a stock.
Investing in the stock market or any security is an uncertain endeavor on its own. But you amplify your risk when you use borrowed money to purchase securities. If your investments perform well, you could grow your account balance faster than trading with cash. Unfortunately, you could end up losing more than the amount you invested if your investments perform poorly.
Just as with other advanced strategies like options trading, fully understanding margin accounts is critical before you decide to invest in this manner. Run through scenarios. Make sure you’re aware of how much money you stand to gain or lose based on potential performance outcomes. Margin trading might be a better fit for those trading based on a short-term investment strategy versus those with long-term financial goals like building their retirement accounts.
If you can’t afford the possibility of losing money if your investments falter, margin trading may not fit your situation. Those with ample reserves to offset any potential margin calls may be better positioned to take advantage of the benefits of margin trading.
FinanceBuzz is not an investment advisor. This content is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.
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