Margin Accounts

What you need to know and what you need to do.

The Basics:

If you have opened an account at a brokerage, you have probably seen the term “margin,” “margin account,” or “buying on margin.”  If you joined Robinhood, they call it “Robinhood Gold.” If you are new to trading you likely have no idea what these terms mean.  In a nutshell, a margin account is the way a brokerage loans you money that you can then use to trade in the market with.  This is great to have some extra money to invest when your investments do well because it amplifies your gains.  It can be extremely dangerous, too, because it also amplifies your losses.

The Catch:

Nothing is free, there are no free lunches.  Every brokerage that is willing to lend you money is only willing to do so for a profit.  The brokerage loaning you the money will make a profit regardless if you do or not.  These rates vary and if you are looking to begin a margin account, take your time and do your research. On a quick Google search, I found interest rates ranging from 2.5% to 10%, so take your time and make sure you are getting a deal that works for you.  Robinhood will loan you $2,000 for a flat rate of $10 per month.

The Details:

Regulations are fairly tight around trading on margin, this is to protect the lender and the borrower.  There are not many restrictions on what you can do with your own money but federal regulators have set rules for trading with borrowed money.  The minimum size of a margin account is $2,000 cash, which the brokerage will loan you an additional $2,000 on top of.  The typical accounts are 2:1 so the brokerage will loan you up to the amount of cash you put in.  Minimum trade amount is $2,000.  Margin accounts cannot be used to buy stock in an initial IPO.  Individual stocks must cost at least $5 per share.  All trades must be made within the NYSE or NASDAQ markets, so no penny stocks.

Let’s say you put $2,500 into a margin account, the brokerage matches that amount and loans you an additional $2,500, giving you $5,000 to trade with.  You find a stock that is priced at $5 per share and purchase 1,000 shares.  Let’s say after a year the stock has doubled in price to $10 per share so your account now shows $10,000 in value.  You would then sell that stock and repay the loan with interest, assuming a 5% simple interest rate.  So you will owe the brokerage $2,500 in principle and $125 in interest.  Deduct the $2,500 you originally invested and you are left with a profit of $4,875.  Had you made the same investment with only the $2,500 you had in cash, you would have only profited $2,500.  So using a margin account in such cases will nearly double your profits.

The Downside:

Let’s say you make the same investment and the stock loses 1/2 it’s value.  So in this scenario, the stock is worth only $2.50 a share after a year.  Once you sell you have only $2,500 of the original $5,000 invest and you will still be required to pay the interest of $125 in addition to the principle of $2,500.  This would actually put you in the hole  by $125 because you had to pay back the loan with interest.  So while trading on a margin account can allow you to make more money, on the flip side, you can lose more than you invest.

The Complications:

Day trading margin accounts work a little differently than traditional margin accounts.  Day traders have a minimum deposit of $25,000 cash which is considered a “maintenance margin.”  Every dollar in excess of the maintenance margin can receive a loan at a maximum rate of 4:1 so a cash deposit of $35,000 will give you $40,000 ($10,000 x 4) in buying power.  If your account drops below $25,000 in cash, there are penalties including a downgrade of your account.  All these amounts are federal minimums mandated by law and each brokerage may put stricter rules and higher minimums in place.

The Take-Home:

Stay away from margin accounts until you are well versed in the market.  I am an advocate for everyone getting involved in their investing and this is the best time in the history of the stock market for everyday people to get involved.  That being said, there are some tools and tricks that should be left to the professionals.

2 thoughts on “Margin Accounts

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