What is a margin account?

If you are trying to learn more about different types of investing, and you already have a brokerage account, you might find yourself looking into margin accounts and wondering, “What is a margin account?”

To put it simply, a margin account is a type of brokerage account, but the difference lies in how you fund the account. When you have a margin account, your broker lends you cash to be used to purchase securities. To learn how this works, the benefits and risks, and whether you should open one, keep reading.

What is margin investing?

To better understand margin accounts, it’s good to have a solid understanding of what margin investing is. Margin investing is when someone 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 investment vehicles available to you.

How do margin accounts work?

Let’s look at how margin accounts work and how to use one.

First, let’s say you buy a stock using a regular brokerage account for $100 and the price rises to $150. You’ve now earned $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, you’ve now earned $100 on this investment. (Don’t forget, though, that part of that $100 is going to have to be used to pay the broker back for the interest on the $50 borrowed.)

However, if the price drops to $20, you’ve now lost more than 100% of your investment. Not only do you lose all of the money that you invested, but you now also owe the broker the money you borrowed from them, in addition to possible fees. In this situation, your return is actually less than what you put in. This is why margin investing can be so risky. If you lose, you can lose big.

Margin account requirements

There are a few requirements that you should be aware of when it comes to margin accounts.

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, too. Often, your broker’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 more clear, but let’s look at the 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:

Risks:

Should I open a cash or margin account?

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 with cash on hand will give you an idea of what it’s like to invest.

If you’re more experienced and you’re confident you can invest using leverage without incurring too much 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?

Although you don’t need to have a margin account to trade most options, there are a handful that do require one. There are certain options transactions that are more complex in nature and can have unlimited risk, so a margin account would be needed to facilitate these trades.

However, you can buy some options with cash accounts with some brokers. This may present limited opportunities, however, as these brokers often have a reduced amount of options to pick from.

The bottom line

Now, instead of wondering, “What is a margin account?” you may find yourself wondering how to open one. If that’s the case, the advisors at J.P. Morgan can support you. Working with an advisor to get you started on a margin account is a helpful way to ensure that you are getting professional guidance and advice as you weigh utilizing more advanced investing strategies.

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