What Is A Margin Account | Definition And Example

Do you want to know what a margin account is? To some investors, this term might be easy to understand or even to explain. However, on the other hand, many people struggle when it comes to what a margin account actually is. Well, in this article, we will share with you the definition of a margin account. Further, we will show you an example. So, let’s take a look at what is a margin account.

What is a Margin Account?

A brokerage account offers you an opportunity to borrow money/funds from the broker. Moreover, with the borrowed money you can buy stocks or securities and this is called a Margin Account. However, since you are using increased cash that you have acquired from your broker, the profit and loss potential will also increase.

Moreover, the broker will also charge interest on the funds you borrow. Here the borrowed funds are generally referred to as margin funds. And, the minimum requirement for using a margin account is to have a trading account of a minimum $2000. But let’s get back to the profit and loss potential of a margin account.

How Is Profit And Loss Potential Higher In A Margin Account?

Suppose you purchase some stocks or securities using the margin funds or the funds borrowed from your broker. After a few days, the price of the stocks that you have bought with that margin funds increases by a particular amount. Moreover, the amount is more than that of the interest to be paid on the borrowed amount. In that case, your profit will also be more than that you would have had if you had used only the funds you possessed.

Similarly, on the other hand, after a few days, if the price of those purchased stocks or securities decreases, you will have to sell them off on that decreased price. Well, in this case,  your loss will also be more than the loss that you would have had if you had invested only the funds that you owned.

Keeping in mind that Margin accounts are not for everybody. The higher profit and loss potential that comes with a margin account requires previous experience and knowledge in this field. Moreover, it is highly recommended that investors who don’t have a high level of understanding of such extra risks should not do this.

Example Of A Margin Account

Suppose you have a margin account with a fund of $5,000 in it. And, you are willing to purchase some shares of a stock with a current price of $10/share. However, you want to buy 1000 shares by investing a total of $10,000. In such cases, you need to borrow a margin fund of $5,000 from the broker. By doing so, you can purchase a total of 1000 shares successfully.

Suppose after a few days of your purchase, the price of the stock gets doubled. In that case, you will get $20 for each share you sell. In other words, you will be making a total earn of $20,000 for all of your shares.

Here your profit will also be almost doubled after paying back the amount that you have borrowed. Furthermore, your profit won’t be exactly doubled as you will have to pay commissions and interest on the amount you borrowed.

However, on the other hand, the price of the share can go down. In other words, if the price of the stock goes down to $5/share, you will lose all of your own money. In such cases, the broker will send you a notification that they are going to close your position. Moreover, they will close your position unless you don’t add more funds to your account. These warnings are Margin Calls.

Moreover, in case you get a Margin call, you will have to add the required amount of funds to your account within a given number of days. However, another option you will have to fulfill the Margin call is by selling some of the stocks you possess. As an investor, you can use any of these mentioned methods to offset the difference between the maintenance margin and the current value or price of the stocks you own.

Brokerage Firm’s Rights In A Margin Account

Due to the high risk of the loss involved in lending money or funds to investors, brokers or brokerage firms have some exclusive rights in the case of Margin accounts. Some of the essential Brokerage Firm’s rights are as follows:

• If the value of the stocks held or possessed by an investor in his Margin account drops below the level of maintenance margin, the broker has a right to make a Margin call (as explained earlier)
• Also, the brokerage firm has the right to ask the investor to increase the funds in his account whenever needed.
• They can also ask an investor to sell his stocks or securities whenever they suppose their own funds are at risk of being lost.
• The brokers also have the right to sue any investor if he is having a negative balance in his Margin account and is not even responding accordingly to the Margin call.

Bottom Line

As clearly indicated above, along with having a high-profit potential, a Margin account also comes with a high loss potential as well. Hence you should think twice before using this option.