What is a margin account?
- A margin account is a type of brokerage account in which your brokerage firm lends you money to be used for purchasing securities.
- To receive the brokerage firm's loan, you must provide collateral in the form of cash or some types of securities.
- Let’s say you buy a $100 stock using a margin account and half of it is funded by you ($50) and the other half is funded by your brokerage firm ($50). If the price increases to $150, your gain is $50 (a 100% return on your $50), before interest and fees.
- However, margin accounts come with a lot of risk. If the price drops to $20, you’ve now lost more than 100% of your investment. Not only do you lose on the part of the money that you invested, but you now also may owe the brokerage firm money back for the money you borrowed from them.
If you’re learning about different types of investing and you already have a brokerage account, you might be wondering what a margin account is.
A margin account is a brokerage account that lets you borrow from your brokerage firm to buy securities. Below, we’ll cover how margin works, potential benefits and risks, and how to decide whether it’s right for you..
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What is margin trading?
To better understand margin accounts, it’s good to have a solid understanding of what margin investing is. Margin investing is when an investor borrows money from a brokerage to buy securities. This is very different from using a regular brokerage account to buy securities, because in a regular account, you are using cash that you’ve deposited into the account to make your purchases.
Margin investing comes with more risk because you are investing money that has been borrowed and must be repaid. And when you borrow money from the brokerage, you have to pay interest on it as well. On the other hand, margin accounts increase your purchasing power and the investments and strategies available to you.
How does a margin account work?
Here’s a simple example of how margin can amplify gains – and losses.
First, let’s say you buy a stock using a regular brokerage account for $100 and the price rises to $150. You’ve now gained $50 on this investment. Conversely, if the price drops to $20, you’ve now lost $80 on this investment.
If you apply this same example with a margin account, the numbers come out differently. Let’s say you buy a $100 stock using a margin account and half of it is funded by you ($50) and the other half is funded by your brokerage ($50). If the price increases to $150, your gain would be $50, which is a 100% return on your $50, before interest and fees.
However, if the price drops to $20, you may lose more than your initial investment. Not only could you lose the $50 you put in, but you may still owe your brokerage money (plus interest and fees). In some cases, your brokerage firm may issue a margin call or sell securities in your account to cover what you owe.
Margin account requirements
There are a few requirements to be aware of when it comes to margin accounts.
- First, you’ll have to complete a margin agreement to confirm that you understand the risks involved with margin trading.
- When you initially purchase a security on margin, you typically must have at least 50% of the total purchase amount as equity in your account; if you want to buy a stock for $1,000, you must have at least $500 in your account.
- You must have a minimum of $2,000 in equity in a margin account to trade on margin, according to FINRA Rule 4210, but check with your broker in case it’s higher. If your account is flagged as a pattern day trading account, that minimum may be much higher.
- You generally must maintain at least 25% equity in your margin account, although brokerages may require more.
It should be noted that margin accounts are subject to rules set by the Federal Reserve Board, the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange (NYSE), and your brokerage’s own policies. Often, your brokerage firm’s policies may be stricter than the regulator’s policies. This is to protect both the broker and the investor from running into any extreme losses when trading on margin.
Margin account benefits and risks
By now, the risks of margin accounts may be clearer, but let’s look at some of the benefits and risks together to give a more complete picture. These may vary depending on a particular brokerage’s policies and investor circumstances.
Benefits
- More purchasing power
- Potential for increased returns
- Possibility of lower interest rates than some other types of loans (please consult current rate disclosures)
- Potential for tax-deductible interest (consult your tax professional for eligibility details)
- Broader range of investment options and strategies that may be available to margin account holders
Risks
- Investing money that is borrowed
- Chance of losing more money than invested
- If investments lose value, the possibility of owing more than the account’s equity
Cash account vs. margin account: Which should you open?
When deciding to open a cash or margin account, you should decide what your level of comfort with investing is. If you’re a new investor who is starting out as a beginner, it probably makes more sense to open a cash brokerage account. This way, you can get more comfortable and knowledgeable about investing with a brokerage account while only investing with cash you have on hand. Experiencing gains and losses this way can help you understand what investing feels like.
If you’re more experienced and understand how leverage can increase risk, a margin account could be an option for you. It’s a good idea to start small to make sure you get a good feel for investing with a margin account before you start making big investment decisions.
Do I need a margin account to trade options?
You don’t need a margin account to trade many options strategies, but there are certain option transactions that are more complex in nature and can carry unlimited risk and may require margin approval to place.
Some brokers allow certain options strategies in cash accounts, but availability may be limited based on the strategy and your approval level.
The bottom line
If you’re considering opening a margin account, working with a J.P. Morgan advisor can help you understand the risks, costs and requirements before you decide.
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