Margin Accounts
Lesson in Course: Stocks (expert, 7min)
We played on seesaws as kids. How can we make our money do more work with less effort?
What it's about: We can invest with borrowed money in margin accounts.
Why it's important: Leverage magnifies our gains AND losses.
Key takeaway: Leverage is extremely risky so use with caution. Limit the risks by using stop orders and making sure there is enough collateral in the account.
We might not remember the lesson about levers and simple machines from school, but the seesaw below might be familiar. Levers allow us to move things with less work.
Our favorite philosopher was caught saying:
Give me a lever long enough and a fulcrum on which to place it, and I will move the world. - Archimedes
He knew that, with enough leverage, a little effort could make big things happen. The same principle applies to investing. By using margin, we can apply leverage to magnify returns with less money.
What is margin?
In a cash account, we need the full cash amount to buy or sell an investment. On the other hand, a margin account allows us to make trades with some of our cash or investments and borrow the rest using the investments and cash in the account as collateral. Some types of trading, such as using stock options or short-selling, can only be done in margin accounts.
The concept is similar to getting a mortgage to buy a house. The bank keeps the house as collateral until we pay off the loan. Collateral in our margin account assures our broker that we can pay back what we borrowed.
Borrowing money like this is known as leveraging your position. A leveraged position amplifies the potential gains and losses of an investment.
Let’s say we want to buy a share of Amazon, $AMZN, and it’s trading at $3,000 per share, but we only have $1,500 of cash available. In a margin account, we can borrow the other $1,500 to make the purchase.
The upside
Imagine the share price goes up to $3,500, and we sell our share. We’d pay back the $1,500 we borrowed on margin and pocket the other $2,000. This is a $500 profit on our $1,500 investment, a sweet 33% return.
If we bought the share in a cash account, we would have put up all $3,000, and our $500 profit would be a 17% return. Still a nice return but not as high as if we bought the share on margin.
The downside
Now imagine the share price goes down to $2,500, and we sell our share. We’d pay back the $1,500 we borrowed on margin and pocket the other $1,000. This would be a $500 loss on our $1,500 investment, a rough 33% loss.
If we bought the share in a cash account, we would have put up all $3,000, and our $500 loss would be a 17% loss—still a tough loss but not as bad as if we bought the share on margin.
Calling for reinforcements
The amount we borrowed from our brokerage in a margin account.
As with any loan, the margin balance will accrue interest. The difference is that there is no repayment schedule as long as we hold enough collateral in the account.
Brokerages may require us to keep somewhere between 25% - 40% of the total account value as collateral, either cash or the value of your investments. If the value of our collateral falls below that, we’re faced with a margin call.
A margin call occurs when the value of our margin account falls below the broker's required amount. We are asked to transfer more money to maintain the margin balance.
A margin call means that we need to add more collateral to our account. We can add cash, add other investments, or close some positions to lower the margin balance. If we don’t meet the margin call, our broker has the right to close out any open positions, such as forcing a sale of stock, without our approval.
From our previous example, let’s say the price of AMZN stock plummeted to $2,000, and the maintenance margin is 30%. That means our collateral, the value of our equity in AMZN is $500 ($2,000 account value - $1,500 borrowed on margin) and is only 25% of the account value. Since this is less than the 30% we need to keep in the account, we have to meet a margin call.
Actionable ideas
Investing with margin can be a powerful tool to increase your returns, but it’s much riskier.
Consider your risk tolerance and your financial circumstances since you’ll have to pay interest on the margin loan. You'll also be required to deposit more money or investments if you're faced with a margin call.
You can limit these risks by using protective stop orders that limit losses from any stock positions and keeping enough collateral in the account.
Supplementary materials
Glossary
In a cash account, all transactions must be made with available cash or long positions.
A margin account allows an investor to borrow against the value of the assets in the account in order to purchase new positions or sell short.
A margin call occurs when the value of our margin account falls below the broker's required amount. We are asked to transfer more money to maintain the margin balance.
The amount we borrowed from our brokerage in a margin account.