One way to get more leverage is to set up a margin account. These accounts use a portion of the stocks within them as collateral for what are called margin loans. Such loans are made by brokerage firms for the purpose of buying more stock. As with other investment instruments and strategies, there are both risks and benefits that go along with this strategy.

The Risks

Margin accounts amplify the results of any trading strategy. This makes the use of margin accounts riskier than typical, straightforward buying and selling. With a margin account, the broker must be paid back the entire amount of the loan even if the stock price drops. Just as importantly, the value of the collateral stock can also drop. When this happens, investors must replenish that stock or pay down the loan to keep everything within the agreed-upon limits. Such events can cause the investor to be forced to sell into a down market, losing even more money than the original amount invested, before everything settles.

The Benefits

The same amplification effect that increases risks also increases potential benefits. This is why many investors use margin accounts even if they can afford to pay cash. One can increase profits with margin account funding because the broker only has to be repaid the original loan amount even if the prices of the stocks soar. Investors thereby end up with far more profit than would otherwise be possible under these circumstances.

Other benefits are much the same as those that arise from loans in general. With more money available, investors can buy stocks that would otherwise be out of reach. An improving portfolio with margin account funding can therefore be more diversified than would normally be possible.

Are Margin Accounts Worth the Risk?

There is no one risk profile that fits everyone, so it’s impossible to make a blanket statement. The main thing to remember is that it’s possible to lose 100 percent of the money that is at stake in a margin account. This risk can be mitigated by various strategies for separating essential funds from non-essential ones, avoiding taking out overly-large margin loans, and similar practices.

The other important thing to remember is that everyone has a different psychological tolerance for risk and drive for reward. One person may find the maximization of potential benefit to be the key factor in his or her decisions, while another may want to minimize risk as much as possible. These different drives will require different investment strategies to meet them.

Usually, many investors will find margin accounts worth their risk as long as basic, common-sense practices are used. Avoid the temptation to go “all in” during heated market shifts. Instead, calculate everything wisely so that the risks won’t outweigh the potential rewards.

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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.

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What Is a Margin Account?

A margin account is dedicated to providing funds to buy stocks. In a nutshell, account holders borrow funds from their brokers. The stock they already own serves as collateral. Typically, the margin account will allow the borrower to obtain more funds than the collateral is worth. For example, someone with $5,000 worth of stock in the account may be able to borrow $5,000 to invest in other stocks.

Because of how margin accounts work, risk is an inherent property. On the upside, they allow investors to buy into stock that they could not otherwise afford. This makes it possible to reap big benefits since the investors can purchase rising stock when a good opportunity appears. The downside is that stocks can fall before the investor has a chance to resell them. Then, the loss is compounded by the need to repay the broker.

How Much Can I Borrow on Margin?

As with other loans, multiple factors go into determining the borrowing limit. The amount of collateral is important – someone who has a brokerage account with $1 million in stock will almost always be able to borrow more than someone whose entire account is worth $2,000. Credit rating and other indicators of stability also matter.

How Are Margin Rates Calculated?

Each brokerage has its own formula for calculating the interest rates on margin accounts. There is, however, a general formula that will give a rough idea of how much interest that will need to be paid. For this, divide the brokerage’s interest rate by 360 in order to arrive at the daily interest rate. Then, multiply the result by the amount borrowed and by the number of days it will remain unpaid. By doing this, investors can determine how much interest they’ll actually have to pay and thereby be able to factor this into their calculations.

Risk Management

When calculating the potential end results of a margin trade, it’s important to run the numbers on losing scenarios as well as winning ones and understand that the use of margin means that you can lose more money than you have deposited in your account. This due diligence helps ensure that the investor will be financially ready for any eventuality.

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