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How Margin Accounts Work

Margin Calls

A margin call is never good news. It means that your margin account's equity has dropped below 25 percent of the account's total value (or some higher percentage, if your brokerage agreement requires a more stringent maintenance minimum).

Getting back to our example scenario, you've got $1,000 in equity in an account worth $6,000 in stocks. That's less than 25 percent, so the broker issues a margin call. That means you have a limited amount of time -- usually a day or two, as spelled out in your brokerage agreement -- to put enough cash into the account to bring it back up to the 25 percent maintenance minimum. In this case, you need to send them $500 to bring the equity up to $1,500, which is 25 percent of $6,000. You are essentially buying $500 worth of your own stock when you do this, partially repaying the $5,000 loan you used to start the account.

This is why it's strongly recommended that you have the cash reserves to make a margin call if you plan to buy stocks on margin. If you can't make the margin call in time, the broker can sell off the stocks to bring your account back to the maintenance minimum. This can be disastrous because it always happens when the stock has lost value. The smart strategy might be to hold the stock until it regains some value over the long term, but your broker doesn't care about that. The only thing important to a broker is minimizing the financial risk of the loan.

In the worst case scenario, the stock drops in value so drastically that even selling off every last share doesn't return enough cash to repay the loan. When that happens, not only do you lose your initial $5,000 investment, you end up owing the broker money.

The important thing to take away from this is that margin accounts are risky and obviously work best for buying stocks you're very confident about and have done extensive research on. The old adage that "it takes money to make money" is also very true -- you need the cash reserves to absorb margin calls and avoid devastating losses. If you're new to investing, you should probably stay away from margin accounts until you're more experienced. In fact, many brokers won't allow investors to buy on margin unless they either have a lot of cash or can prove a record of stable, smart investments.