Margin Account: Definition, How It Works, and Example

What Is a Margin Account?

The term margin account refers to a brokerage account in which an investor's broker-dealer lends them cash to purchase stocks or other financial products. The margin account and the securities held within it are used as collateral for the loan.

It comes with a periodic interest rate that the investor must pay to keep it active. Borrowing money from a broker-dealer through a margin account allows investors to increase their purchasing and trading power. Investing with margin accounts means using leverage, which increases the chance of magnifying an investor's profits and losses.

How a Margin Account Works

If an investor purchases securities with margin funds and those securities appreciate in value beyond the interest rate charged on the funds, the investor will earn a better total return than if they had only purchased securities with their own cash. This is the advantage of using margin funds.

On the downside, the brokerage firm charges interest on the margin funds for as long as the loan is outstanding, increasing the investor’s cost of buying the securities. If the securities decline in value, the investor will be underwater and will have to pay interest to the broker on top of that.

If a margin account’s equity drops below the maintenance margin level, the brokerage firm will make a margin call to the investor. Within a specified number of days—typically within three days, although in some situations it may be less—the investor must deposit more cash or sell some stock to offset all or a portion of the difference between the security’s price and the maintenance margin.

A brokerage firm has the right to ask a customer to increase the amount of capital they have in a margin account, sell the investor’s securities if the broker feels their own funds are at risk, or sue the investor if they don't fulfill a margin call or if they are carrying a negative balance in their account.

A margin account may not be used for buying stocks on margin in an individual retirement account (IRA), a trust, or other fiduciary accounts. In addition, a margin account can't be used with stock trading accounts of less than $2,000, in most cases.

Margin on Other Financial Products

Financial products, other than stocks, can be purchased on margin. Futures traders also frequently use margin, for example.

With other financial products, the initial margin and maintenance margin will vary. Exchanges or other regulatory bodies set the minimum margin requirements, although certain brokers may increase these margin requirements.

That means the margin may vary by broker. The initial margin required for futures is typically much lower than for stocks. While stock investors must put up 50% of the value of a trade, futures traders may only be required to put up between 3% to 12%.

Example of a Margin Account

Assume an investor with $2,500 in a margin account wants to buy a stock for $5 per share. The customer could use additional margin funds of up to $2,500 supplied by the broker to purchase $5,000 worth of stock, or 1,000 shares.

If the stock appreciates to $10 per share, the investor can sell the shares for $10,000. If they do so, after repaying the broker's $2,500, and not counting the original $2,500 invested, the trader profits $5,000.

Had they not borrowed funds, they would have only made $2,500 when their stock doubled. By taking double the position, the potential profit was doubled.

Had the stock dropped to $2.50, though, all the customer's money would be gone. Since 1,000 shares times $2.50 is $2,500, the broker would notify the client that the position is being closed unless the customer puts more capital in the account. The customer has lost their funds and can no longer maintain the position. This is a margin call.

The above scenarios assume there are no fees; however, interest is paid on the borrowed funds. If the trade took one year, and the interest rate is 10%, the client would have paid 10% times $2,500, or $250 in interest. Their actual profit is $5,000, less $250 and commissions. Even if the client lost money on the trade, their loss is increased further by the $250 plus commissions.

The Bottom Line

Margin trading is extremely risky due to the magnified losses that can occur. Although margin trading is regulated, with a significant amount of rules in place, it should still only be done by experienced traders who understand the ins and outs, requirements, regulatory aspects, and the potential for high losses.