Did you know it’s possible to set up a six figure trading account with only a few thousand dollars from your pocket? This is called margin. The ability to set up a margin account is offered by most brokers and can give you a lot of buying power without much of any cash investment on you part, but there has to be catch right…

What is a Margin Account?

To answer this question, we really need to understand the two main types of accounts: cash accounts and margin accounts. So, what is a cash account and what is a margin account? Let’s start with cash. A cash account is simply that; it is a trading account that is 100% funded by “cash”. This account is set up through your broker and will give you the ability to buy and sell securities with the “cash” in your account. A margin account, is almost exactly the same, the big difference being: your broker actually provides you a loan, or margin, to trade with. This gives you more buying power without having to invest any more capital.

Should I Have a Margin Account?

Ultimately this will be up to you to decide. I will break down what a margin account is and identify the risks and benefits involved so that you can make an educated decision.

How Does a Margin Account Work?

Let’s first jump into what a margin account is and how it works. As I mentioned in the intro, a margin account is basically a loan from your broker. With that loan though, there are quite a few rules, regulations, and terms that you need to know and will need to adhere to if you decide to open, and trade with, a margin account. Some of these rules and regulations can get fairly convoluted and can change based on which broker you choose. I will do my best to explain the general concepts of these regulations but you should always check with your broker before opening a margin account.

Opening an Account – Minimum Margin

The first thing you need to know regarding opening a margin account is the “Minimum Margin”. The minimum margin is the minimum amount of capital required to open a margin account.

The NYSE (New York Stock Exchange) and the FINRA (Financial Industry Regulatory Authority) are the primary regulators for margin accounts. They specify that in order to open a margin account you need to have a minimum of $2,000 in capital deposited into your account. Often brokers require more than this, however this is the absolute minimum.

Once you have your margin account open with your initial $2000 and you want to start trading, how much “borrowed money” or “margin” will you have to trade with? That is highly dependent on your broker. Each one will have different rules regarding how much they will loan you to trade with so you will need to check with them directly. For the rest of the article let’s just assume they are willing to give you an additional $4000, making the total buying power in your account $6000.

Let’s Make a Trade – Initial Margin

You have $6000 and are ready to trade. You find a security and want to go all in with your whole $6000 account. While, not only being a really bad idea, you can’t! According to the regulators any new position you put on must be funded with at least 50% of your own capital. Therefore, you can only borrow up to 50% of any given trade. In this case that would allow you to put on a position of up to $4000. This is called the “Initial Margin”.

I am going to assume that you are a smart trader, and that you are not going to risk your whole portfolio on one trade. So let’s assume that you entered a trade with a position size of $1000, $500 of your capital and $500 borrowed. Now that you are in the trade there are a couple other things you will need to consider.

First, since you have officially now borrowed that money and have put it to work, you will need to pay interest to your broker on that money. Interest rates vary from broker to broker, but that cost needs to be factored into your trading strategy.

Keeping Your Account Open – Maintenance Margin

Second, now that you are in a trade you need to maintain what is called “Maintenance Margin”. Basically, you need to maintain a minimum amount of equity in your account to maintain your margin account. The FINRA dictates that this needs to be at least 25%; however, many brokers require a higher percentage.

Let me try to explain how this works with an example. Let’s go back to our first example and say that you have $2000 of equity in your $6000 account and that you put on a position with a value of $4000 ($2000 of your equity and $2000 borrowed), i.e. you bought $4000 of a stock. Now let’s say this trade is not a good one and goes down after you purchase. Now your positions value is only $3000. At this point do you have enough equity in the account to maintain your maintenance margin? Let’s do the math. Your position is worth now $3000 and your borrowed $2000 to put on the trade initially, that leaves you with $1000 in equity. $1000 is 33.3% of your $3000 position so you are still above that threshold and can continue in the trade. What would happen though if your broker had a maintenance margin requirement of 35%?

Avoid at All Costs – Margin Call

Once you get under maintenance margin threshold of your broker, they then have the right to issue a “Margin Call”. A margin call says that your broker can either sell your positions without your consent in order to get their investment/loan back, or they may require you to deposit additional capital into your account to get you back above the maintenance margin threshold.

Risks and Benefits of a Margin Account

There are a lot of extra regulations that come with a margin account, so why would you want a margin account? The simple answer is: To have more leverage or buying power within the market. Many people enter the market with the desire to “get rich quick”, but do not have the capital to put on large trades that would give them 4-5 figure profits, so they look to margin. But with great reward comes great risk as well. When trading with a cash account you can only lose what you have, if you have $2000 and you lose all of if then you are done and can walk away. However, with a margin account it would be very easy to lose more money than you have.

Say you are in that $4000 position that we just talked about; but, rather than it going against you and falling to $3000 it actually falls to a $2000 value. At this point the broker is probably going to issue a margin call and sell your position to get their $2000 loan back. Of that transaction, you get none of your initial capital investment back because the position is only worth $2000 and you owe your broker $2000. Worse yet, you are still going to owe your broker fees, commissions, and interest on the borrowed money. It is also a possibility that your position could have totally collapsed and is now only worth $1000. Now, not only do you owe all those fees, you also have to pay your broker back the $1000 of theirs that you lost!

Pattern Day Trader (PDT)

You may be asking yourself what is a “Pattern Day Trader” and what does it have to do with me? Well, let me explain. Basically the FINRA states that anyone who completes 4 or more day trades (opens and closes a position with the same day) within a week is considered a pattern day trader. If you have a margin account, you need to have at least $25,000 in equity in your account to day trade.

Maybe you aren’t planning to day trade so this won’t affect you, but not having the ability to day trade is quite crippling to many traders and their strategies. With a cash account this rule is not in effect, it only affects people with margin accounts. If you are on a cash account, you can day trade just about as much as you like so long as you have enough cash to pay for the trades.

Conclusion

If you have made it this far I commend you! We covered a lot of facts and rules that can very often get a little muddy and convoluted. At this point, though, you need to make a decision. Do you need the added leverage provided by a margin account and does that leverage outweigh the rules, regulations, and risks that are associated with a margin account?

Key Terms:

• Margin – margin is simply put “borrowed money”.
• Margin Account – An account in which the broker lends the account holder money to invest or trade with. This “loan” is backed by both the initial cash invested by the account holder and by the securities purchased within the account.
• Cash Account – A cash account is one that is 100% funded by the account owner with no borrowed funds.
• Minimum Margin – The minimum account required by law to open a margin account. This value is a minimum of $2000 and may be higher based on the broker you choose.
• Maintenance Margin – The FINRA requires a minimum amount of equity in a margin account at any given time. The regulation states that at least 25% equity is required at all time, however that number is often higher as it can be set by the broker as well.
• Initial Margin – This value is the percentage of any purchase made within the account that must be funded by the account owner’s equity. Each trade must be funded with a minimum of 50% equity.
• Borrowed Capital – Is basically the portion of the account that is borrowed, i.e. the margin. For instance, if the account has a value of 100k and the initial equity investment was 50k then the other 50k would be considered “borrowed capital”
• Margin Call – a margin call happens when an account falls below the “maintenance margin” level calculated by the broker. At this point the account owner would be required to depositmore money in order to get back up to that maintenance level or their positions may be liquidated.