My Financial Independence Journey » Investing » A Primer on Margin Accounts
A Primer on Margin Accounts
Recently, I got my brokerage account upgraded to a margin account. So I though that this would be a good time to talk about what margin accounts are, how they work, and some of the benefits and risks involved. I also wanted to discuss my thoughts on how to get the most out of a margin account.
What Is Margin?
Margin is basically nothing more than a loan from your broker. The collateral for the loan are the stocks and cash in your investment account.
How Does Margin Work?
Margin may be best described by the following example.
Let’s say that you have $100,000 in your account. Normally, if you wanted to buy additional stock, you’d have to cough up all the extra money. But if you have a margin account, you can circumvent that roadblock by borrowing the extra money from your broker. Most brokers will offer what is known as 1:2 margin (read “one to two margin”). What this means is that for every dollar of cash or stock that you have in the account, the broker will be willing to loan you another dollar.
So if you have $100,000 in your account, your broker will be willing to loan you another $100,000. Now, you’re probably thinking, “Sweet, let’s just go load up another hundred grand worth of quality dividend stocks.”
Not so fast there, Skippy.
Margin Interest
Remember that the broker is loaning you the extra money. And like any other loan, you have to pay interest on it. So you’re not going to just go and buy another $100,000 worth of dividend paying stocks and live happily ever after. You’re going to be paying interest on all of the money borrowed from your broker. And the interest rates will be far greater than the typical dividend yield.
So where does margin interest fall on the scale of interest rates?
Typical margin interest rates tend to be around 7-8%. I suppose that’s better than a credit card, but that’s not an interest rate that you want to be paying over the course of the entire year. Margin trading is best suited for very short term investments.
Basic Margin Use Examples
While we’ve established that margin is not suitable for a long-term buy and hold investor, margin can offer some great advantages to the short term investor or speculator looking to make a quick profit.
Let’s consider the following textbook examples of how to use margin to make a profit.
Example 1a – things go right:
You have $10,000 of available cash in your account. Stock XYZ is on fire and you want in on some of that action. You could just buy $10,000 worth of XYZ. But instead you decide to harness the power of margin. You borrow $10,000 from your broker and invest in $20,000 worth of XYZ. XYZ soars up to $25,000 and you sell. You pay your broker back the $10,000 that you borrowed and pocket the $5,000 profit (less commissions and interest). A $5,000 profit on a $10,000 investment is a 50% return. Pretty badass!
Example 1b – things go wrong:
You have $10,000 of available cash in your account. Stock ABC is on fire and you want in. Again, you could just buy $10,000 worth of ABC, but remembering your incredible returns on XYZ, you take the margin route. You borrow $10,000 from your broker and invest in $20,000 worth of ABC. Unfortunately for you, ABC is on fire in the same manner as the Hindenburg. Your investment goes crashing down to $15,000. You sell off the stock, but you still have to pay the broker back. So you’re left with a $5,000 loss (plus commission and interest). A negative $5,000 return on a $10,000 investment is a negative 50% return. Now would be a great time to drown your sorrows in some Scotch. But you can’t afford any booze after that loss.
Example 2a – things go right:
You have $100,000 in your account. Stock XYZ is on fire and you would like to capitalize on that, but you don’t happen to have any additional cash laying around. So you tap your margin, and borrow $20,000 of your broker’s money to buy the stock. The stock shoots up in price and you sell it back for $25,000. After paying your broker back the $20,000 that you borrowed, you have $5,000 in profit (less commissions and interest). A $5,000 profit on a $0 investment is epic!
Example 2b – things go wrong:
You still have $100,000 in your account. Stock ABC is on fire, but you lack extra cash at the moment, so you borrow $20,000 from your broker. ABC crashes and your investment drops down to $15,000. You sell ABC and pay off your broker. You’re left with negative $5,000 from that trade (not to mention additional losses from commissions and interest). You actually managed to make negative $5,000 on a $0 initial investment. That’s an epic fail.
Maintenance Requirements
Remember how I said that margin in a loan and the collateral is your equity? If you buy a stock on margin, your broker will require you to keep a certain amount of cash or securities in the account to act as collateral. This is called the maintenance requirement.
For example, if your broker has a maintenance requirement of 30%, you must have enough account value to cover 30% of what your borrowed.
To make things a little more tricky, maintenance requirements are based on the market value of the stock. So if the stock price goes up, so does your maintenance requirement.
Maintenance requirements get very complicated and will vary based on the broker, the price of the stock purchased, or if you’re selling options. Consult your broker’s margin handbook for further information.
The next question that you should be asking yourself is: What happens if you fall below the maintenance requirement? Answer: You get hit with a margin call.
Margin Calls
When your account value dips below the maintenance requirement, a margin call is issued. If this happens you must immediately deposit new funds into your account to bring it back up to the minimum maintenance requirement.
You can meet a margin call in one of three ways. First, you can deposit funds (cash). Second, you can deposit stock from another account. Third, you can sell off some of your stock in order to raise the funds.
If you fail to meet the margin call within the specified time window (around 2 days), your broker has the right to start selling off your equities in order to force you to meet the margin call. Yes, your broker will sell off your stocks. And no, your broker doesn’t care what what stock you would prefer to sell off first.
Conclusions
This was meant to be a basic introduction to a margin account. Just because you have a margin account, doesn’t mean that you have to use it. The focus of this article was the use of margin when buying stocks. But my primary interest in a margin account is combining it with the sale of put options, which I will save for its own post.
Readers: Do you have a margin account? Have you used margin in the past? What was your experience?
Written by MFIJ
Filed under: Investing · Tags: margin, margin account, margin trading
20 Responses to "A Primer on Margin Accounts"
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Thanks for the new topics, margin investment. This another investment under your belt.
I haven’t done any simple margin investments yet. But I wanted to get the primer on margin out of the way before I talk about using margin and puts, which is a strategy that I just started using.
Nice primer MFIJ! Margin can definitely be a tricky thing. Personally I don’t plan on ever using margin to make traditional purchases, however, down the road I definitely plan on using it to sell naked puts to boost my options income.
I don’t plan on using margin to make traditional purchases either. But I think it’s important to understand how a margin account works before you want to get into selling naked puts.
Oh margin! I use to be thoroughly acquainted with margin back in my “trading” days. I actually have had a margin call when I was trading the Euro and the brokerage allowed me to ride out the position over the weekend. Turns out my analysis was right and I ended up making $30k in 2 months
$30K in two months is awesome! I’m guessing that’s something that you weren’t able to pull off on a regular basis.
The euro was crashing at the time and I just rode the wave. I wouldn’t recommend FOREX trading to 99% of the people who ask me about it. Heck I don’t even do it anymore. With a family I have too many obligations to speculate.
Great post! Very informative and easy to read. I agree that in general margin interest rates tend to be 7 – 8% However, Interactive Brokers is usually much cheaper than that. Currently it is 0.78 – 1.65% depending on the amount that you are borrowing.
I think my broker tends to be a little bit on the pricy side. But I’m not planning on keeping money on margin and racking up interest. I’ll be using margin and put selling so if I get assigned a stock, I’ll just transfer some money over from my emergency fund to cover whatever I owe.
I shy away from using margin because, like you pointed out, when things go wrong they go really wrong. I’m just not comfortable with the added risk.
I would shy away from margin as well. But it couples greatly with selling puts. Stay tuned for some more articles outlining my thoughts on that subject.
Great breakdown of margin accounts! I have never had them, but have dealt with many investors who have. The thing that always made me shake my head was people who just racked up all sorts of margin debt and interest by making silly mistakes. It’s not for everyone and requires some attention to what you’re doing…BUT it can be a great tool. I have been wanting to open a margin account for a while and need to just do it. I want to have one so I can dabble in shorting stock.
Thanks! I agree, margin can cost you a ton of money if you don’t know what you’re doing. That’s why I avoided it for so long. But felt confident getting a margin account now that I’ve developed an actual strategy for using it with selling puts.
Too many things can go wrong with using margin to purchase stocks so I won’t be doing that. Plus I can never tell the direction that a stock is going to move, although I have noticed if I sell it shoots up or if I buy it drops. So maybe my readers should use margin to juice their returns whenever I announce a sell.
I do like having the margin access though for selling naked puts. I’ll be looking forward to your primer on that.
In the short term stocks always move in the opposite direction of the way I want them to. If I want them to go down, they go up. If I want them to go up, they go down.
I’ll be using my margin account similar to how you use yours. It’s all about selling puts.
I have and still do make selective use of margin. Now it plays more of a timing role for me than a core part of my strategy. Margin has helped accelerate my investments over the years. I had been capitalizing my margin interest into my margin loan. When my loan ballooned over $250k, I knew it was time to take some action to bring it down to something more manageable, which is where it is today.
A $250K loan! Wow! I can see why you wanted to scale that back. I’m not really interested in using margin by itself. For me, the fun comes in combining margin with selling puts. I’ve got a whole post coming up about that soon.
That’s neat you opened an account. I currently don’t have one. I guess I could open one but I don’t have any plans to trade on margin so I never bothered. I just wouldn’t want to have to deal with possible margin calls.
You don’t need to worry about a margin account for most normal investing. But margin accounts really let me be aggressive with put selling. I’ve got another article about that coming up. Outside of the puts, I don’t really plan on doing any margin trading.
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