How Margin Accounts Work

When you buy stock using a cash account, it's a relatively straightforward process: You give the broker money and the broker gives you shares of the stocks you want to purchase. You own the stocks outright and can control how the broker deals with them -- that is, you decide when and how much to sell. Your equity in the stocks is 100 percent. If the value of the stock rises, all of that profit is yours. If it falls, the opposite happens. For example, if you buy 100 shares of a stock worth $100 per share, you own $10,000 worth of stock. If the stock increases in value to $150 per share, you now own $15,000 worth of stock. If the stock falls to $75 per share, you now own $7,500 worth of stock. You don't owe anyone any money, other than broker commission fees.

Buying on margin means you're only paying cash for a portion of the total shares you purchase. The rest is purchased as a loan from the broker. The collateral from this loan is the stock you purchased with cash. Here's an example:

You only have $5,000. You open a margin account with your broker and purchase 100 shares of a stock that's worth $100 per share. You now own $10,000 in shares -- even though you only invested $5,000. The broker loaned you the other $5,000 by giving you those additional shares. The $5,000 in shares you paid for with your own cash is used as the collateral against the loan. This is the most important aspect of margin accounts to understand, because it works just like any other loan collateral -- if the broker thinks you can't repay what you borrowed, he or she can repossess those shares. Where margin stocks are concerned, this is a lot worse than the bank taking your car because you missed too many payments. Why? Because of the minimum margins and maintenance minimums you have to keep on the account. We'll explain those in the next section.

When the stocks you bought on margin increase in value, everything is fine. You can use the increase in value to repay the loan portion of the investment to your broker. If your $5,000 margin investment in $10,000 in stocks goes up to $15,000 in value, you can repay the loan and own all the shares you have.

If the stock's value drops, however, you can get into trouble quickly. That's because of the minimum margin. The Financial Industry Regulatory Authority (FINRA) requires a minimum investment of $2,000 in margin accounts -- and many brokers will make you pay more. The Federal Reserve Board only allows you to borrow up to 50 percent of the total cost of stocks you buy on margin. Finally, FINRA also requires a maintenance minimum of 25 percent, which is the minimum amount of cash that must be held in a margin account relative to the value of the stocks. Brokers can set different minimum margins and maintenance minimums, as long as they are more stringent than the federal rules. They often tie maintenance minimums to the perceived volatility of the stock -- if they think there's a good chance the stock's value will drop drastically, the maintenance minimum might be as much as 75 percent.

This can be a problem because the value of your stock declines comes out of your equity first. To use our example scenario, if the stock declines to $80 per share, your original $10,000 in shares is now only worth $8,000. However, this loss of value comes out of the $5,000 equity you started with. That means you're left with only $3,000 in equity. Since the total value of the stock is now $8,000, you've got 37.5 percent equity in the account, so you meet the 25 percent maintenance minimum. However, if you cash out your stock now, you'll only get back $3,000 out of your original $5,000 cash investment.

If the stock's value drops even further, things get much worse. Imagine that the stock declines to $60 per share. The stocks you own are now only worth $6,000, losing another $2,000 in value. That $2,000 again comes out of your equity, which started out at $5,000, dropped to $3,000 and is now down to $1,000. At this point, your $1,000 in equity is less than 25 percent of the value of the account. That's when the broker issues a margin call (in the form of a phone call or e-mail). Read the next section to find out why a margin call could spell disaster for your investment portfolio.

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.