When opening an account with a brokerage firm, you will have to choose between a cash account and a margin account. One is fully funded by your own money, while the latter gives an option to borrow more capital money from the broker. In this article, we are going to talk about the basics of a margin account and how it works in trading.
What is a margin account?
A margin account is an account offered by a broker that allows investors to borrow money from the firm to add to their capital in buying securities. An investor can deposit 50% of the amount he needs to invest in a certain security. Afterwards, he can borrow the rest from the broker. Of course, this is not for free. The broker charges the investor a certain interest for the money he borrowed and uses the securities invested as collateral. This interest continues to add up until the borrowed money is paid, that is why a margin account is more commonly used for short investment transactions only.
The basics of margin trading
A margin account lets you buy more securities than you’d normally be able to with the money that you own. Brokers have different requirements when it comes to opening a margin account. Most brokers, however, require an initial investment of at least $1,000 or more to open a margin account. This initial deposit is what you call the margin and it is the client’s initial equity in the account.
When buying securities with a margin account, a broker can lend the client up to 50% of the total purchase price of the stock. This makes the purchasing power of the client doubled. Thus, he can buy securities double the amount he can pay using his own money.
However, there are some restrictions on using a margin account. The client must maintain his equity at a certain percentage as dictated by the broker. This is what you call maintenance margin percentage. While this percentage may vary depending on the broker, there is an requirement minimum maintenance margin of 25%. This amount is computed with the current whole purchase value of the securities in the account. When the maintenance margin falls lower than the equity of the client (disregarding the borrowed funds from the broker), then the broker is will need to make a margin call.
During a margin call, the broker will require the client to deposit more money to cover up the missing amount on the maintenance margin. The broker has the right to impose a certain date by which the client has to deposit the said amount. If the equity of the client falls further below the maintenance margin, the broker has the right to liquidate the securities even without the permission of the client.
Examples of margin transactions
Assuming you want to purchase 1,000 shares of company ABC worth $20 per share. You have to deposit $10,000 into your margin account; then proceed to borrow the other 50% from the broker, which makes your buying power equivalent to $20,000. If the value of the stock rises to $25 per share, and you sell your 1,000 shares, you end up with $25,000. You would need to repay the broker with the $10,000 you borrowed, and then you can keep the remaining $15,000 for yourself. In this scenario, if you deduct your initial investment of $10,000, you have gained a profit of $5,000 from that transaction (excluding the interest and commissions for the broker).
Now what if the market value of the shares decreases into $11 per share instead? You end up having $11,000. Remember, you still need to meet the maintenance margin, which is 25% of the whole price. In this case, your maintenance margin should be $2,750. However, if you deduct the borrowed funds from the whole purchase value of your securities, you would only end up with $1,000. This is clearly below the maintenance margin requirement. The broker then proceeds to make a margin call. If you opt to sell all your securities instead of depositing more money, you would only be able to get $1,000. This results in $9,000 worth of losses from your initial deposit (still excluding the interest and commission you owe the broker).
Trading on a margin account is like a double-edge sword. It may potentially double your gain, but you also increase the risk that you lose more money than you can afford. When this happens, you still have the responsibility to repay what you have borrowed. As well as the interest and commission that you owe the broker.
It is important to establish good communication with your broker before opening a margin account. Here at Trade12, we prioritize the concerns of our clients. With our competent ECN brokers, you can be assured that you would be well guided in all your transactions. For international clients, you need not to worry as we have multilingual customer service representatives to assist you at all times. Make sure to read about Trade12 reviews to make sure you only trust the best. Register an account now and start trading!