Investors are often tempted to try new strategies in an attempt to increase their potential returns. But advanced trading methods are usually complex and not suitable for beginner investors. This includes margin trading. In this article, I’ll explain how margin accounts work, cover some key terminology, and let you know who margin trading is best suited for.
What Is a Margin Account?
A margin account is an investment account where the investor is able to borrow money from the broker to buy stocks or other securities. The money held inside a margin account is used as collateral for the loan.
Not everyone can open a margin account. Investors must apply to the broker and be approved before opening their account and borrowing on margin.
How Margin Works
To understand how margin works, let’s use a basic example. Suppose you purchase $3000 of stock in a regular cash account (no margin), and your investment increases by 10%. You will have earned $300 on your investment, and its value will rise to $3300.
If you invest in a margin account with a maximum margin rate of 30%. You could invest $10,000, a combination of your cash of $3000 and $7000 of borrowed funds. You’re still only investing $3000 of your own money, but now you can purchase $10,000 of stock.
In this case, if the stock rises by the same 10%, you will earn $1000 on your investment, less any interest that you must pay on the borrowed funds.
You’ve only invested $3000 of your own money, but you’ve earned $1000, which is a 33% return (not including fees). This is how an investor can use margin as a form of leverage to potentially enhance an investor’s returns.
So, why doesn’t everyone use margin trading to earn higher returns? It’s a matter of risk.
The Risks of Margin Trading
While margin trading gives investors the opportunity to enhance their returns, it can also enhance losses. I’ll use the same numbers from the previous example to show you what can go wrong when trading on margin.
Suppose you purchase $3000 of stock in a cash account. However, this time, the stock dropped by 10%. Your investment is now worth $2700. If you choose to sell the stock, you will realize a $300 loss, or you could hold onto the stock and wait for its value to go back up.
Now, let’s say you used your 30% margin to purchase $10,000 of stock. You’ve invested $3000 and borrowed $7000 on margin. The stock drops by 10%, and your investment is now worth $9000. In this situation, your investor’s equity has dropped from 30% to 22%. In other words, you have insufficient cash to cover the 30% margin.
A few days later, your broker assesses your account and triggers a margin call. Your option is to sell the stock or cover the margin by adding cash to your account. If you sell the stock at a 10% loss, you will incur a $1000 loss on your cash (after paying off the margin loan of $7000). Instead of a 10% loss, it’s 33%.
As you can see, margin accounts give you the potential to enhance your returns if your investment goes up in value. However, the results can be disastrous if your investment drops in value. I used an example of a stock falling by 10%. Imagine the consequences if the stock fell by 30% or 40%.
About Margin Calls
When you take out a mortgage to buy a house, you are using a margin. Your equity is the downpayment you’ve contributed, and the mortgage is the margin. Over time, your house may rise and fall in value. But banks don’t reassess the value of your home very often, only if you decide to refinance your mortgage. Thus, you don’t have to worry about margin calls with banks.
However, when you trade in a margin account, your broker will constantly assess your account and your margin position. Because stocks are always fluctuating in value, you may receive a margin call at any time if you’ve maximized the margin in your account.
There are a couple of ways you can avoid margin calls. The first is to avoid margin trading altogether. For most investors, the risks are simply too high. If you are an experienced investor and wish to trade on margin, ensure you always have enough cash available to take care of margin calls if and when they occur.
Margin vs. Cash Accounts
Margin accounts and cash accounts have many similarities, but they are very different and attract different types of investors. I’ve listed the characteristics of account type below:
Cash Accounts
- Available to investors of all levels
- Lots of online brokers to choose from
- Can trade a wide range of investments, e.g., stocks, bonds, ETFs, GICs, mutual funds
- Can only invest your own cash
- Must pay for all purchases by the settlement date
Margin Accounts
- Not recommended for beginner investors
- Must apply and be approved, similar to a loan or line of credit
- Not all online brokers offer margin accounts (but most do)
- You can borrow funds to purchase investments
- Using margin increases your level of risk
- Using margin is optional (can choose to only invest your cash)
- The amount you can borrow can change frequently
- Your margin is not unlimited; there are caps on borrowing
Common Margin Account Terms
Margin trading can be confusing for inexperienced investors. Here are some common terms to become familiar with before opening a margin account.
Cash account: An investment account where the investor deposits 100% of the money to be invested. There is no borrowing permitted in a cash account.
Margin account: A margin account gives the investor the option to borrow money from the brokerage to invest.
Minimum margin: the minimum amount you must deposit into your margin account before you are eligible to trade.
Maintenance margin: the amount of equity you must keep in your margin account at all times.
Initial margin: The amount of an investment’s purchase price that must be covered by cash by the accountholder of a margin account.
Margin call: A requirement by your broker to increase the value of your account to cover a margin deficiency. You can do this by depositing additional funds or selling some other securities. Most brokers give investors 2-5 days to cover a margin call.
Margin debt: The debt taken on by an investor for the purpose of trading on margin.
Stop Loss: A type of trading order used to limit potential losses on a trading account. Margin traders may employ a stop-loss order to minimize losses when trading on margin.
Final Thoughts on Margin Accounts
Margin trading is not suitable for the vast majority of investors. By trading on margin in a brokerage account, you take more risk than trading with your own money. In addition to the potential for bigger losses, you must pay interest on your margin loans. That said, many experienced investors have had success with margin accounts.
If you’re considering opening a margin account, I recommend that you consult with an investment professional before proceeding. If margin trading isn’t for you, consider opening a cash trading account with one of the many online brokerages in Canada.
