Investors have used margin accounts to boost their buying ability for years. With these accounts, the investor borrows some money from his or her broker and uses an amount of stock – the margin – to secure the loan. Because stock is the collateral, there are some big risks inherent in the arrangement. There are, however, also big benefits that can be gained when things go right.
What Are the Risks to Consider when Using a Margin Account?
One of the most important things to keep in mind with a margin account is that the use of leverage is a magnifier. It makes success or a loss all the greater.
With that in mind, it’s easier to understand why these accounts can be so much riskier than taking out standard loans or just paying in cash. One good example comes from Investopedia. They imagine a hypothetical account with $20,000 worth of securities, half of which are paid for in cash and half of which are purchased with margin. If the shares fall 25 percent, the investment becomes worth $15,000. However, since the broker needs to get its entire $10,000 back, you end up with $5,000 – a 50 percent loss on the amount you had put up out of your own pocket. If you hadn’t used a margin account, you would have had to put up $20,000, but you would still have $15,000 at the end of the day. That’d be a loss of 25 percent.
This can also be explained in another way: You take on all of the losses when things go sour, while the broker gets its money back regardless of whether or not the bet went well.
Another risk is that the stock may fall to the point that the collateral for the account is no longer enough to cover the margin. Then, the broker may issue a margin call. This term is often preceded by modifiers like “the dreaded” or “the feared.” That’s because the investor has to add cash or sell stock to cover the margin. This can force investors to sell into a falling market, which further compounds the losses.
What is the Potential Upside of a Margin Account?
The upside is that it’s also quite possible to increase profits with margin account trading. Using the above example of an account with a total of $20,000 a 25 percent increase in the price of the stocks would only produce a profit of 25 percent – if all of the stock had been purchased by the investor. However, if half of the stock was bought with the broker’s money, the profit to the investor becomes 50 percent. The broker merely gets its money and a little interest back.
Because of the potential for total loss of funds, margin accounts aren’t for the faint of heart or those in precarious financial conditions. However, when they are used wisely, they can also be excellent tools for maximizing successful bets on stock performance.