Margin Account. Definition and In-Depth Guide About Margin Account
Margin Account is a term used in the financial industry to describe an investment vehicle that allows investors to gain exposure to equity markets without having to invest their own capital. The margin account can be thought of as a type of futures contract, where instead of buying or selling shares of stock directly, one buys or sells contracts for future delivery on those stocks.
In this case, the investor does not have any ownership interest in the underlying security but rather has only a contractual right to buy or sell it at some point in time. This means that if there are no buyers when the contract expires, then the buyer will lose money and the seller will make a profit. If however, there are enough buyers willing to pay more than what they would receive by holding onto the contract until expiration, then both parties benefit from the transaction.
The advantage of using margin account over direct investment is that the risk associated with investing in equities is spread out among many other investors who may also want to participate in such transactions. Margin trading is often done through brokers like E*TRADE Financial Corporation, Charles Schwab & Co., Inc., TD Ameritrade Holding Corp., Fidelity Investments, Interactive Brokers LLC, etc.
In addition to these advantages, margin account allow traders to borrow funds against securities held within them. These loans are called "repos" and are typically secured by collateral provided by the broker. Repos provide liquidity to the market because they enable large institutions to purchase large amounts of assets quickly. For example, a brokerage firm might use its repurchase agreement line to finance purchases of $100 million worth of IBM common stock. When the RPA matures, the broker must either repay the loan or return the collateral. Because the broker's reputation is tied up in the success of the company whose stock serves as collateral, the broker cannot afford to fail to meet its obligations under the terms of the repo. Thus, the broker usually agrees to extend additional credit to cover outstanding positions.
A major disadvantage of margin account is that they carry high fees. A typical fee structure includes: a maintenance charge; a borrowing rate charged during periods of heavy activity; and a lending rate charged during times of low volume. Maintenance charges vary depending upon how much cash is deposited into the account. Borrowing rates are based on the current value of the portfolio being financed. Lending rates are determined by reference to the prevailing prime rate plus a percentage which covers overhead costs incurred by the broker. As a result, even though margins offer great potential benefits, most individual investors do not take full advantage of them due to the cost involved.
Another drawback of margin account is that the amount borrowed is limited to 50% of the total value of all securities owned by the customer. Therefore, if a trader owns 100 shares of XYZ Company and decides to open a margin account, he/she could borrow up to $500. However, if the same trader decided to trade 500 shares of ABC Company, she/he could still only borrow up to $250. Since the maximum leverage available varies according to the number of shares traded, it becomes difficult for small-time investors to obtain sufficient financing to enter new trades. Moreover, since the size of each position determines the amount of funding needed, smaller investors tend to avoid opening margin accounts altogether.
As mentioned above, another problem faced by individuals wishing to engage in margin trading is finding suitable sources of financing. Traders generally rely on two types of lenders—brokerage firms and banks. Banks lend money to customers primarily to fund short-term needs. They rarely lend long-term debt instruments unless the borrower has an excellent track record with the bank. Brokers, on the other hand, specialize in providing financing to their clients. In exchange for receiving interest payments from borrowers, brokers pay commissions to the lender. The commission paid depends on the type of security purchased and the length of time over which the transaction takes place. Typically, brokers receive higher commissions when transactions involve longer maturities.
Things to know About Margin Account
The following information should be considered before deciding whether to invest in a margin account.
1) You will have to deposit at least 20 percent of your investment capital to establish a margin account. This minimum requirement may change without notice. If you wish to maintain a margin account but do not want to make any initial deposits, you can request that we transfer funds directly out of your existing account. Please note that this service does incur a fee.
2) Your brokerage firm must approve your application prior to establishing a margin account. Once approved, you will need to provide additional documentation such as copies of recent tax returns or proof of income. Failure to comply with these requirements may cause us to close your account.
3) We cannot guarantee that our services will enable you to earn enough profit to cover losses caused by declines in market prices. For example, if you purchase stock through a margin loan, you might lose more than what was originally invested because of declining share values. Also, there is no assurance that you will ever recover the original principal balance owed on the margin loan.
4) There is always some risk associated with investing in stocks. Stocks fluctuate in price and sometimes decline sharply. When this occurs, you may sustain substantial loss of part or all of your investment.
5) As previously stated, we are unable to predict future trends in the financial markets. Accordingly, past performance is not necessarily indicative of future results.
6) Our services are intended solely for retail investor use. Individuals who buy and sell large amounts of securities are required to meet certain regulatory guidelines. These regulations include maintaining adequate cash reserves and collateralizing positions held within margin accounts.
7) Some states prohibit residents from engaging in activities involving investments where they reside. Check with your state's securities regulator regarding applicable laws.
Frequently Asked Questions
Q: What happens if I am late making my payment?
A $10 per day penalty applies after 30 days. After 60 days, the entire amount becomes due immediately.
Q: Can I get a refund if I decide against using the service?
A: No refunds are given once the contract period begins. However, you may cancel your agreement at anytime during its term.
Q: How much money can I borrow?
A: Generally speaking, the maximum borrowing limit varies depending upon the broker used. It also depends on how many shares you own. To determine the exact figure, please contact your broker.
Q: Do I have to sign anything?
A: Yes. Before opening a margin account, you must complete a form authorizing us to open a new line of credit on your behalf. This document contains important disclosures about the risks involved in margin loans.
Q: Will I be charged interest when I receive dividends?
A: Dividends received while an order is outstanding become subject to interest charges. The rate applied is determined by the prevailing prime lending rate plus 1%.
Q: Is it possible to withdraw money before maturity date?
A: Margin loans mature according to their terms. In most cases, the borrower has three business days to pay back the borrowed sum. If he fails to do so, the lender may charge him a fee equal to 10% of the unpaid portion.
Q: Are there any fees?
A: You will incur a monthly maintenance fee which covers administrative costs incurred in processing your transactions. Additionally, you will be charged a transaction fee based on the size of each trade executed.
Q: Does my broker know what trades I make?
A: Not unless you tell them. Your brokerage firm does not need access to your trading records. They only see information pertaining to your portfolio as a whole.
A margin account offer investors the opportunity to increase leverage. Leverage allows individuals to invest larger sums than would otherwise be allowed without incurring additional risk. For example, someone could purchase 100 shares of stock worth $1,000 but still maintain sufficient funds to cover that position should it fall below market value. By leveraging his initial investment, the individual now controls 200 shares of stock valued at $2,000. He stands to gain or lose more than twice as much as he did initially.
The downside of this strategy is that margin debt increases rapidly. As such, we recommend that all traders carefully monitor their balance sheet. We suggest that you consider closing out positions prior to reaching full capacity. Also, remember that margin calls are triggered automatically; therefore, you cannot avoid these events simply by ignoring them.