Margin Accounts
How Does A Margin Account Work?
Here’s how a margin account works. Lets say you have a cash account. You will pay for the stocks you purchased in full. In a margin account, you would be allowed to buy more stock for the same amount of cash or, conversely, the same amount of stock with less cash. For example, in a cash account, you would pay $100 for 10 shares of stock that is valued at $10 per share. With a margin account, you would pay $50 for the same amount of shares, borrowing the other 50 percent of the cost on margin. If the stock price increases from $10 to $15 a share, the cash account client would realize a 50 percent return. However, the margin account client who borrowed 50 percent of the purchase price would realize a 100 percent gain.
Margin account offer increased purchasing power for buying securities. You can borrow against your current holdings to purchase more securities. For example, if you own 100 shares of stock valued at $50 per share, your margin account is worth $5,000. You can borrow up to 50 percent of this value to purchase more stock. Therefore, you can use an additional $5,000 to make your purchase, which would make the market value of your account $10,000 and your debit balance would be $5,000.
This strategy provides leverage for trading, which means that you can purchase more securities for less money. Lets go back to our example in which the market value of the account is $10,000. The price of the stock jumps from $50 a share to $75. Assuming that you have 200 shares, you would enjoy an unrealized gain of $5,000. Since you used margin to bring your market value to $15,000, your percentage gain would be 100 percent of the initial investment of $5,000. Nice huh?
Selling a stock short happens when you would borrow stock from a firm and sell the stock with the hope that the stock's price falls. Margin accounts can also be used to enhance anticipated gains from the short sale of a stock. If the price falls, you would buy it back at the lower price and return it to your broker dealer. You get to keep the difference in price. As you can see…margin accounts enhance the potential gains from this type of trading technique.
Special Memorandum Account - SMA
What does Special Memorandum Account - SMA Mean? The discussion of margin accounts always bring up a key component of a Margin account i.e. a special account where excess margin generated from a client's margin account is deposited. Also known as “Special Miscellaneous Account –SMA”
Investopedia explains Special Memorandum Account - SMA...
The purpose of an SMA is to lock in any gains realized in a client's margin account. Consider the situation where stock within a client's margin account realizes a capital gain and creates excess margin. If this excess amount is held in the account and the stock position produces a capital loss at a later date, the client would lose his or her gain entirely. An SMA can also hold interest and dividend payments from long positions and proceeds from closing out a securities position.
Risk
The return potential of margin accounts attracts many investors. While the rewards of buying on margin can be great, the potential losses can be just as dramatic. For every 100 percent gain there is the potential for a 100 percent loss. In a cash account, your risk is limited to the amount of money that you have invested. In a margin account, your risk includes the amount of money invested plus the amount that has been loaned to you. As market conditions fluctuate, the value of your marginable securities will also fluctuate, causing a change in your overall account balance and debt ratio. As a result, if the value of the securities held in your margin account depreciates, you will be required to deposit additional cash or make full payment of your margin loan to bring your account back up to maintenance levels. Clients who cannot comply with such a margin call may be sold out or bought in by the brokerage firm. So be careful!
Additional Risks Involved With Trading On Margin (Caution Given By FINRA)
There are a number of additional risks that all investors need to consider in deciding to trade securities on margin. These risks include the following:
- You can lose more funds than you deposit in the margin account. A decline in the value of securities that are purchased on margin may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securities in your account.
- The firm can force the sale of securities in your account. If the equity in your account falls below the maintenance margin requirements under the law—or the firm’s higher "house" requirements—the firm can sell the securities in your account to cover the margin deficiency. You will also be responsible for any short fall in the account after such a sale.
- The firm can sell your securities without contacting you. Some investors mistakenly believe that a firm must contact them for a margin call to be valid, and that the firm cannot liquidate securities in their accounts to meet the call unless the firm has contacted them first. This is not the case. As a matter of good customer relations, most firms will attempt to notify their customers of margin calls, but they are not required to do so.
- You are not entitled to an extension of time on a margin call. While an extension of time to meet initial margin requirements may be available to customers under certain conditions, a customer does not have a right to the extension. In addition, a customer does not have a right to an extension of time to meet a maintenance margin call.
- It is important that investors take time to learn about the risks involved in trading securities on margin, and investors should consult their brokers regarding any concerns they may have with their margin accounts.
Other Resources For Your Use In Considering and Using Margin Accounts